EXECUTIVE SUMMARY
In the last twenty or thirty years a veritable arsenal of environmental policies have been proposed, discussed, and at times implemented. If this array of environmental weaponry is to be critically evaluated for its effectiveness, the objectives to which it is targeted first have to be specified. Ultimately, those objectives must focus upon efficient economic growth.
Efficient economic growth encapsulates the appropriate environmental policy goals. The notion of efficiency encompasses such matters as the "quality of life" as well as the "quantity of goods consumed". It implies making the best use of resources, including natural resources and the environment, so as to maximise community well being. Efficiency requires carefully trading off the costs and benefits of resource use and environmental policy. It leads to policy recommendations which balance competing demands on resources rather than imposing total bans and moratoriums on productive activities.
Over the last two centuries, economists have given the concept of efficiency considerable intellectual rigour. In this chapter, insights from this body of thought are distilled and applied in an environmental context.
In an ideal world, efficient patterns of resource use could conceivably be determined by some omniscient planner. However, such planned utopias are impossible to achieve. Assembling and correctly weighing the requisite information is a dauntingly formidable task. The information itself is scarce and outcomes from its application are rarely certain. Moreover, bureaucratic managers have incentives to pursue political and institutional goals rather than maximise the productivity of the assets they control; furthermore, the constraints they face in the watchful use of valued inputs are more limited and therefore less compelling than those confronting private sector owners and managers. The risk that publicly owned or directed instruments will fail to protect the environment adequately is at least as real as the risks found with privately owned firms; the likelihood that publicly owned bodies will pursue the goal using excessive resources is much higher.
It follows that in a world of uncertainty, environmental policy should focus on providing broad boundaries within which the diverse knowledge and skills of individuals are channelled to seek out efficient environmental solutions. To achieve this, individual ownership and market-based incentives need to replace the political motivations of public resource owners.
Defining individual property rights to valued resources assigns liability in the case of anticipated and unforeseen circumstances. It creates incentives to adapt to changing economic and environmental circumstances. By defining boundaries rather than processes, individuals are given the flexibility to adjust and respond. In much the same way that genetic diversity and the processes of natural selection help ensure species survival in a shifting environment, so allowing individual creativity and entrepreneurship to seek out efficient market solutions ensures economic survival in a changing world.
The built-in incentives created by well defined, individual property rights have been recognised for centuries. Aristotle noted that:
What is common to the greatest number gets the least amount of care. Men pay most attention to what is their own: they care less for what is common. (Politics, Book II, Chap 3.)
In many circumstances, fully defining and allocating property rights in environmental resources is sufficient to create the appropriate incentives for the owners of the resources to seek out their efficient uses. But vesting of property rights in individuals is not always possible, for example, in the case of air where considerable definitional difficulties would be involved. Even if vesting of air were possible, this may well result in excessive transaction costs as the multiplicity of owners sought compensation and approvals from each other prior to embarking on any activity which might infringe on the rights to the resource.
A key aim of this work is the exploration of avenues where property rights approaches to environmental goods have a place. Where property rights solutions are not practicable, it does not follow that environmental problems should be redressed by regulatory means. The costs of regulatory approaches can outweigh any likely benefits. If regulatory approaches are to be considered, these should exploit market-based incentives as far as practically possible. Market-oriented policy tools allow efficient trade-offs and can save resources due to fully defined ownership. To this end, available approaches include:
- taxes, fees and charges; and,
- setting limits to total emissions, whilst allowing resource users to trade their rights to pollute within these overall bounds.
These mechanisms constitute a twilight between true market based approaches (in which the role of government as an independent actor is minimised) and "command and control" approaches. Command and control approaches require a high degree of government intervention. They include direct government ownership of resources and regulations which define and limit technologies, processes and resource use. Their main deficiencies are two-fold. First, they offer inadequate incentives to the search for more cost-effective approaches. Secondly, command and control approaches suffer from a scarcity of information available to the bureaucratic planners who formulate the specific decisions; this severely hampers the abilities of such approaches to facilitate efficient resource allocation.
EFFICIENCY OF RESOURCE USE
MARKETS AND EFFICIENCY
Over the past two centuries economists have grappled with the notion of efficiency and sought to tease out the myriad implications of this far-reaching concept. Stripped down to its essentials, efficiency means making the best use of resources to ensure that community well-being is maximised. Resources include natural resources, capital, labour, knowledge and inherited institutions and cultural values. An essential element of the pursuit of efficiency involves taking energetic steps to reduce waste and to ensure that valued goods and services are provided with minimal cost. Equally important is the constant search for new and changed needs and consequential adjustments to outputs and inputs as these are discovered.
Meeting of needs requires trade-offs. We cannot have all the goods and services we want. Nor can we maximise the enjoyment of our leisure time without compromising our abilities to earn the where-with-all to afford it. What is to be maximised is human welfare registered by the decisions individuals make based on their own unique sets of preferences.
Accurately establishing the relative strengths of wants or "needs" has proven possible only through the use of markets. Markets allow people to act according to their own judgements based on their preferences and their capacities to pay. The sum of these individual preferences for goods and services allows suppliers, conscious of their own capabilities, to determine supply responses capable of offering an adequate return. Competitive pressures also force suppliers to constantly re-examine their offerings and find less costly means of production and distribution.
An allocation of resources is said to be efficient if the resources cannot be transferred to other uses so as to make someone better off without, at the same time, making anyone else worse off. At the heart of this is a mutual willingness to trade on the part of the buyer and seller operating within an environment in which all things of value are individually owned. Only then can we be certain that both sides of the transactions are balancing the various opportunities they face, putting an appropriate effort into gathering and dispersing information, and adequately comprehending the risks and the opportunities foregone by making particular purchases and sales. Only when there is freedom to acquire and exchange commodities and information can we be certain that a mutual gain will emerge from transaction.
Economic efficiency is most usefully thought of as comprising two components: technical efficiency and allocative efficiency. Technical efficiency requires that inputs be arranged so that the output is produced at least cost. Allocative efficiency means the inputs are brought to bear in producing the pattern of goods which consumers value most.
Environmental attributes are part and parcel of the notion of economic efficiency. Transactions and resource allocations which do not take environmental concerns into account are unlikely to be efficient.
Goods and services which are to be consumed or owned to the exclusion of others have their worth verified by individuals' acts of purchasing; but this is a highly uncertain yardstick for those goods and services, such as parks and coastline, which offer wide benefits whether or not payment is made for them. Such jointly used foods, where there are difficulties in blocking access to those not contributing to their provision, are usually termed "non-excludable" goods. The joint usage of many environmental services by a large number of people often makes it difficult to ensure that individual decisions embody the full consideration of environmental attributes. Where benefits of environmental amenities must inevitably be widely shared, disaggregated and individualistic market mechanisms may not always reveal their true worth. Because people will automatically obtain those benefits, they have strong incentives not to outlay their personal resources to obtain that access. In many cases, this calls for a more intrusive role for government than that of simply holding the ring in which transactions freely take place.
In making this point, it is important to bear in mind that environmental goods are not alone in having characteristics of non-excludability. Almost all transactions have spillover effects on non-contracting parties. One's neighbour's remodelled house will impact on the pleasure and perhaps the value of one's own house. An influx of new neighbours from Asia or southern Europe is likely to generate a supply of different restaurants which widen the diversity of choice for those previously living in the area. Widespread intervention to factor in all these spillovers would destroy the efficiencies and opportunities which markets create.
At issue is when government intrusion is necessary and how it is to be delivered. Discovery of true needs other than by market processes is very difficult; provision of these needs by government agencies will normally require excessive resource use because, unlike firms in competition with each other, government agencies do not face the same imperatives to constantly search for changes in needs and cheaper means of meeting them.
VALUES AND EFFICIENT RESOURCE USE
The valuations placed on uses of resources when determining whether allocations are likely to be efficient are ultimately those of individual men and women. While some individuals might obtain "utility", or "well-being", solely from the quantity of goods consumed, most, if not all, are interested in the qualities of goods, and almost everyone in developed market economies consumes many more services than goods. There is no foundation to the notion that economic efficiency focuses on the quantity of resources consumed, with an implied undervaluation of the "emotional", "aesthetic" or other less tangible aspects of human existence. Nothing in economics says that only "material" or "functional" uses of resources are to be valued in determining standards of living.
In fact, many of the goods and services supplied in markets are demanded for non-material reasons and a decreasing proportion of our expenditures are motivated by basic needs fulfilment. Our expenditures are not on food, warmth and shelter. They are on appealing taste sensations as well as nutritional needs, on a surfeit of controlled heat, on well furnished houses with reserves of space. Most people do not go to restaurants because they are hungry, although the need to eat is one source of their demand for restaurant meals. Most of the huge annual expenditure on clothing, grooming and cosmetics is clearly motivated by non-material considerations. While some people demand education for the utilitarian motive of increasing their future earning capacities, many also are interested in, and pay for, education as a consumption good. Quantities of all these goods are simply means to ends -- which are partly aesthetic.
ENVIRONMENTAL GOODS AND EQUITY
If market freedoms are to be overridden, economic analysis can offer guidance on the means of effecting this which are less likely to generate waste and distortion. Government reassignment of goods requires one party to relinquish some of his or her assets or income so that another can have more. In principle, decisions of this nature are based on judgements that some people's benefits, over and above the resources they feel able to forego for them, outweigh the disbenefits accruing to those called upon to supply the resources. Political/bureaucratic judgements of this nature involve considerable hazard. Even where soundly based redistribution judgements are possible, these measures typically involve a sacrifice of efficiency. Redistributive measures also generate evasive measures by the party being taxed and encourage potential recipients to position themselves so that they obtain a share of the additional income in the offing. This sort of behaviour will mean goods, services and energies are channelled away from their most productive uses.
It is often suggested that equity within and between generations should also be a goal of environmental policy. This concern with equity arises because a conflict is perceived between economic growth and the maintenance or improvement of environmental standards. As with all aspects of human life, there are many choices to be made between material goods and preservation, clean air, etc. Nonetheless, economic growth has been shown to be by far the most effective way of relieving poverty, cleansing the environment and providing social mobility between and within generations. Environmental goods tend to be more highly valued by individuals and societies with higher levels of income, and at the same time, higher levels of income make their provision more affordable. Krutilla and Fisher (1985) have cited econometric evidence (Boyer and Tolley, 1966) showing that environmental goods are "luxury" goods, that is, demand for such goods increases more than proportionately with income. While Pearce found no evidence of "willingness to pay" increasing with income in his 1980 survey (Pearce, 1980), he has shown a possible relationship between what he refers to as "willingness to act" and per capita GDP (Pearce et al., 1989). The relationship is especially clear when comparing developed and developing nations. Economic development may mean sacrificing some pristine natural endowments, but the alternative will mean less income and, inter alia, a diminished capacity to afford other environmental goods.
These considerations aside, it is unwise to focus on redistribution as an objective of environmental policy. Tax and welfare policies are more direct means of addressing distributional concerns. Environmental goods and services are too narrow a component of overall needs, and environmental policy is too remote from the vast complexity of redistributive goals to be a well targeted instrument for the achievement of satisfactory outcomes in this direction.
Additionally, the conflict between efficiency and equity is far less than commonly believed, since removal of the distortions and privileges which result from political intervention increases both efficiency and equity. In a free market economy, firms earning super profits or "rents" -- incomes above the minimum needed to ensure the continued supply of the goods they control -- are always vulnerable to competitive pressures from others who could supply substitute goods or services. One way of preserving these rents is to lobby government to prevent entry to an industry or market. Thus, tariffs and subsidies, import quotas and licenses, industry regulation, government enforced monopolies, and licensing of professionals and union monopolies all reduce the efficiency of resource allocation, while at the same time creating contrived privileges.
In the environmental arena, government tolerated or mandated interventions are often inimical to equity. Thus, the provision of recreational facilities at low or zero prices, and disallowing those same resources from being employed for alternative uses, is a source of privilege to the mainly middle-class consumers of many of those environmental services. This source of privilege often directly disadvantages poorer individuals such as forest and mine workers. Its indirect effects may be felt more widely where they reduce the income of the community and adversely affect its capacity to provide resources to ameliorate the living conditions of the least fortunate.
THE MAIN OBJECTIVE
The focus of this work is anthropocentric, it is based upon human welfare. Although mankind arguably only has custody and not ownership of the earth, and although consideration may be due to all living organisms, the well-being which must dominate our conceptual framework is that of humanity and its progeny. Accordingly, I advocate the goal of efficient economic growth or, alternatively, efficient increases in the standard of living, as the appropriate objective for environmental policy. The question is: what mechanism will best ensure the meeting of that objective? It is here that markets, incentives, covenants, information and the efficient and fair vesting of property rights can play a crucial role.
INFORMATION, INCENTIVES AND GOVERNMENT INTERVENTION
INTERCONNECTEDNESS OF MARKETS AND ENVIRONMENTAL GOODS
It is axiomatic both to ecologists and economists that everything is connected to everything else. The ramifications of a rise in demand for a good have been explored by many economists. Friedman and Friedman (1980) offer the example of an increased American demand for pencils changing global employment and price signals across a range of activities. The impact of an increased demand for pencils will extend to timber operations in Asia, graphite production, woodworking machinery and so on. At the same time it will lift costs of seemingly unrelated goods which make use of the same materials and thereby reallocate resources, perhaps making some redundant and bringing others into use. Like a sudden shout in a valley, the echoes will continue to have an effect long beyond the point where they are measurable.
A similar interconnectedness is to be found in nature. A change of ocean current may mean some micro-organisms reproduce themselves at a diminished rate, impacting upon the predator chain as other animals adapt or diminish in numbers. The loss of a piece of forest displaces and sometimes leads to the local eradication of whole species of wildlife, the genetic structures of which have become chained to the area and its attributes.
GOVERNMENT AS AN ENVIRONMENTAL REGULATOR
The environment and the economy are complex interactive systems, involving essentially infinite volumes of information from individual actions. These informational complexities leave governments ill-equipped to form and implement detailed intervention strategies to improve people's quality of life. For government successfully to marshal environmental resources, at least two conditions must apply. First, they must have accurate information about how the environment will respond to possible changes in incentives and regulation and, in turn, about people's preferences and possible responses to changes in the economy and the environment. Secondly, policy makers must themselves have the appropriate incentives to consider all relevant costs and benefits and to ignore the mere jockeying of interest groups. The probability of governments getting it wrong is large, not least because of the high stakes to a few powerful players. Government failure is, I argue, far more endemic than market failure in the area of management, including pricing and allocating resources, precisely because of the informational and incentive difficulties inherent in non-market systems.
To apply economic analysis to resource allocation without the benefit of markets and prices, decision-makers must attach values to the margins of use. Such "scientific" management requires that these values are known before an efficient solution can be calculated. Armed with this knowledge, the decision maker would seek to acquire the "correct" information about resource values in alternative uses and to reallocate until marginal equalities hold. The planner's management problem is one of finding the socially optimal allocation. Schematically attractive though this process may appear to be, in practical application it is fatally flawed because it overlooks the vital importance of information. Both the vision, and the naivety, of the traditional resource economics perspective on information is captured by the economist Thomas Sowell (1987):
Given that explicitly articulated knowledge is special and concentrated ... the best conduct of social activities depends upon the special knowledge of the few being used to guide the actions of the many. ... Along with this has often gone a vision of intellectuals as disinterested advisers. ...
If knowledge of values that must be traded off against one another were "special and concentrated", scientific management might be possible. But, as Nobel laureate F.A. Hayek has pointed out, this is not the economic problem which must be overcome in order to maximise the gains from human interaction. As Hayek puts it:
The economic problem of society is ... not merely a problem of how to allocate "given resources" ... if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data." It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of utilisation of knowledge not given to anyone in its totality. (Hayek, 1945:35)
The information and knowledge necessary for effective and "scientific" management trade-offs is only revealed through human action. It is the very diversity, depth and breadth of differing kinds of information produced through exchanges between individuals which is lost through imposed and centralised actions. How can we know how much individuals truly value recreational opportunities, for example, other than by observing how much they are willing to pay for those activities? Merely asking them is unlikely to produce an accurate answer, given that they are not required to pay the cost for indulging their stated preference.
This can be graphically demonstrated by analysing the effects of studies using market research techniques (contingent valuation) to determine the value placed by the community on non-development of a resource. Careful testing of the proposal to mine at Coronation Hill (Resource Assessment Commission 1990) suggested the community would willingly offer a total of $650 million per annum if the site was left unmined. Doubtless other contingent valuation studies would throw up similar numbers to those found in the Coronation Hill study. For one square kilometre of country with no outstanding features, the Coronation Hill result could be construed as placing a value on non-development of Australia as a whole at something over 10000 times the nation's gross national product! There are scores of sites with attributes at least comparable to Coronation Hill. It is not plausible to imagine, given some 20% of Australia is already set aside as wilderness or aboriginal reserves, that the community would pay an additional $65 billion per annum to see 100 more small sites preserved or even $6.5 billion yearly to see 10 more such sites preserved. Certainly no political party would ever go to the electorate promising to tax and spend such incremental sums.
Even if non-market methods of determining choices can accurately reveal true community preferences, the political process of reports, submissions and inquiries which attempts to evaluate public response to alternative management plans is not costless. These informational and coordinating costs of the political process need to be subtracted from any possible gains from a more efficient publicly managed allocation of resources.
In practice, government committees have a tendency to base decisions on simplified, aggregate information. Rational individuals operating in this manner will frequently arrive at a ranking of choices which bears no relation to their individual preferences. This has been demonstrated mathematically in the so-called "Arrow impossibility theorem" (under which a majority of rational people on a committee can be shown capable of preferring A to B, B to C, but then vote for C over A!).
The foregoing is not to suggest that governments are incapable of wise and rational decision making, but it is to suggest that they should do so within constraints as rigorous as those operating in a market. In addition, when governments do decide on an apparently wise course of action, it is often impossible to implement the policy in an efficient way, given perverse incentives, and the difficulties of motivating and monitoring bureaucrats and employees in government enterprises. For private firms, the bottom line -- profit -- provides a residual between the sums people will willingly expend on the products and services provided and the sums assembled to make them available. The measuring rod of profit -- a relatively unambiguous criteria -- is either absent or at best distorted in government enterprises.
ARE THERE ANY GAINS FROM POLITICAL RESOURCE ALLOCATION?
What are the conceivable sources of gains from political as opposed to private management of resources? If individuals can enjoy benefits from scarce resources without making a payment, market provision will not reflect the true benefits. Many consumers may well "free ride" on services provided for others and the provision will receive inadequate compensation for the services, because fewer of them will be produced than would be justified. For example, suppose many consumers enjoy having easy access to scenic views, but once that access is available the benefits of the view cannot be restricted. Because individuals cannot be prevented from accessing the view, they have every incentive to understate their enjoyment if they are asked to contribute to its preservation or improvement; indeed they will look forward to a "free ride". Potential suppliers of such amenities (or those who would forego using them for other purposes) will find fewer willing customers than they would if those who did not contribute could somehow be excluded from access. There will be a tendency, then, to under-supply "non-excludable" goods and services which are positively valued, and to over-supply those, such as many forms of atmospheric pollution, which are negatively valued. The market fails to provide the correct information and supply incentives in these circumstances. However, as previously discussed, market mechanisms will rarely elicit true valuations when individuals cannot be excluded from the "goods" or "bads" which are produced.
Somewhat more problematic is the case where exclusion is possible, so that markets can work, but where there is no congestion from additional consumers. Suppose, for example, that consumers could be excluded from enjoying a view when they have not paid an "entrance fee", but that the number of people wishing to enjoy the view is small enough for additional people to be allowed in without affecting the experience of existing customers. In this case, while exclusion is possible, it is inefficient on one score, because it would cost nothing to allow "free-riders" in to enjoy the view. Nevertheless, if the government were to take over and provide free access to the view -- which would mean access to all -- the failure to charge would mean a loss of information about the value people place on that good vis-a-vis alternative uses of the same resources. It would mean that no solid information was revealed to indicate what additional sites of similar value should be preserved or created.
For reasons already addressed, efficient provision of the good by the government would also be unlikely. Even if management by the political process did capture an efficient allocation of resources in one instant of time, changing preferences, new technologies and different perceptions of proven resource availabilities will all necessitate further rounds of information gathering, thereby escalating the costs.
INEFFICIENCY IN PLANNED ECONOMIES
Information, and especially an asymmetry of information between supervisors and subordinates, is also central to explaining the appalling inefficiency of centrally planned economies. Managers of many government-owned enterprises in these economies know more about production technologies than do the planners, but many of them attempt to use that information advantage to do as little work as possible while paying themselves as much as possible. As Bernstam notes in relation to the USSR,
Like a bad secretary who receives less work from his/her boss than a good secretary, the regulated monopolistic firms are doing well by doing bad. They raise costs, fail new technology, waste resources, and otherwise maximise inputs in order to both justify the cost-based price increases and sabotage the state output pressure.
The waste and inefficiency involved in production in centrally planned economies has demonstrably been accompanied by environmental degradation on a scale far greater than that found in market economies. The fact that the goods and services produced are often not the goods and services which are most valued by consumers represents another major source of waste and inefficiency. This has its parallels within state owned enterprises in Australia. As argued by the Industry Commission (1990), many government-owned enterprises in Australia are very inefficient, and for reasons similar to those creating inefficiency in socialist economies. The inefficiency resulting from government ownership, regulation and reduced competition in many sectors of the Australian economy, exacerbates environmental problems, in that more resources are consumed than is necessary to provide our current standard of living. Given that the government sector at large accounted for 38% of national income in 1988-89, these wastages are a major contribution to any environmental damage associated with industrial activity.
DO GOVERNMENTS LOOK AFTER FUTURE GENERATIONS BETTER?
While it is true that any rational market investor will discount future, relative to current costs and benefits, markets are in fact more likely to look after the interests of future generations than are governments. Politicians' time horizons can often be extremely short, and driven by headlines and public opinion polls. In Australia, there is a Federal or State election almost every year. Future generations do not take part in elections, but they are represented in the capital market. The future sums they are deemed prepared to outlay to enjoy future demands are likely to be quite diverse; this diversity reflects the great variation in appraisals of future worth likely to be held by a large number of individual owners of property.
In contrast to this diversity, government decisions are more likely to oscillate between one extreme or another. Democratically elected governments have a tendency to reflect the wishes of the marginal voter in the currently marginal electorate. Markets, on the other hand, can simultaneously reflect many of the more extreme views on the future value of a resource. Only markets can systematically cater to minority, and indeed minutely represented tastes.
Since the value of an asset hinges on expectations of what some others may pay for access in the future, in market economies those investing in future outcomes -- often labelled speculators -- become the representatives of future generations in today's markets. They are able to perform this function even when the prevailing view of their own generation is that such actions are not worthwhile. For example, a large number of now famous works of art have been preserved by the actions of private investors over many centuries, despite their contemporary unpopularity. Someone with an extreme and strongly positive view about the great value of preserving a resource for future use can bid for control of the resource in the market place, but might be ignored in the political system, or labelled an irrelevant extremist. As an example, private endowments decades ago preserved the nestings of eagles and other birds of prey when both agriculturalists and their contemporary environmentalists saw such actions as harmful. Present day environmentalists take a different view, and the diversity possible from such actions has been vindicated.
More generally, relying on individuals to provide for future generations does not mean future living standards will be ignored. An important component of the standard of living of the current generation is their view both of their own future consumption and the consumption of the next generation. If we leave intertemporal resource allocation to market processes, the evidence suggests that most people will in fact provide for an increased standard of living for the next generation, even though they discount future relative to current consumption.
It appears to be an almost universal human desire to provide a better life for succeeding generations. The enormous sacrifices of countless immigrants to Australia, the US, Canada, New Zealand and similar countries are testimony to the bequest motive. Other telling testimonies are the comments of many citizens of Poland and other Eastern European countries, interviewed on television over the last year, noting that the transition from central planning to a greater reliance on markets may involve short term hardships but will yield great dividends for future standards of living, particularly those of the next generation.
In short, direct government control of resource allocation decisions has proved most ineffective as a means of promoting increased standards of living. On the other hand, private ownership and markets give individuals a strong incentive to minimise the waste of scarce resources, to discover more highly valued uses of those resources under their control, and to preserve the value of assets.
SPILLOVERS AND RISK
There are those who mistrust market determinations of the appropriate degree of the trade-off inherent in environmental protection. In part, these objections to allowing free rein to market forces stem from imperfections in market operations where goods are indivisible or non-excludable or where the vesting of ownership is difficult to envisage. In this book, I recognise that such claims and fears are not without substance; but I also recognise that government failure is likely to be as much, or more of a problem.
Some environmentalists would wish to see political action favouring preservation of some areas notwithstanding community wishes to the contrary. Often, because of the absence of markets and ownership, community wishes are difficult to determine and, as the previous discussion on the Coronation Hill proposal indicated, only those with a remote interest in something will find it difficult to envisage actually having to forego income for it and will therefore tend to overstate its value vis-a-vis the value they would place on it as a market good.
The spillovers or externalities resulting from mutual transactions are in the main adequately taken into consideration by market processes. There is certainly no alternative system available which can allocate goods and services more efficiently. And in spite of the exponential growth in transactions, as the human population has increased in wealth and numbers, the negative externalities have been held in check. In part, for example with air pollution, this has been due to government intervention limiting emissions of pollutants on behalf of the community. But overwhelmingly, measures to combat negative externalities have been made affordable by the increased incomes best arranged by free markets and limited government.
One element of these externalities is risk. For the generality of everyday living, risk accompanies our every actions. Cars create accidents on a scale unknown before the internal combustion engine; certain chemicals concentrated together in industrial processes threaten human life and the integrity of the surroundings which we value; new foods introduce exotic substances, some of which appear to cause cancers. Yet life has become safer notwithstanding these changes. In fact, the pre-industrial wood-fires we used for warmth, the "natural" foods we ate prior to large scale cultivation and processing and the housing and workplaces of earlier millennia all posed much greater risk than those goods that have replaced them. Indeed, Ames (1990), one of the pioneers of testing for carcinogenic substances in foods, points out that "natural" foods are just as likely to have carcinogenic properties as the synthetic substances over which considerable alarm is registered.
Notwithstanding the clear evidence that wealthier is safer and that the key to wealth is a narrow ambit for government actions, there are great concerns about the risks which market activities may pose. Wildavsky (1990) points to the near hysteria found in modern society about risk, he says:
The richest, longest lived, best protected, most resourceful civilisation, with the highest degree of insight into its own technology, is on the way to becoming the most frightened. (Wildavsky, 1990:120)
In the forefront of concerns about risk are concerns about massive changes to the earth's ecosystem resulting from mankind's activities. Figures like Dr David Suzuki, operating through a media concerned more with sensation than objective analysis, have popularised grossly amplified versions of these risks.
There is assuredly a role for government to take decisions on behalf of the community as a whole and to undertake actions for which market mechanisms are unsuitable. National defence is a clear case of such a public good and measures to control urban pollution have already been mentioned as another. But the application of resources in this direction itself carries great risk in denying present and future generations higher living standards. When we divert resources from market activities, we reduce our abilities to afford to combat disagreeable facets of life in the future. Much is made of a putative inter-generational inequity in present generations possibly causing a change in the atmospheric conditions through modifying the ozone filter and greenhouse blanket which form the building blocks of existing living conditions. The jury is still out on the effect of mankind's activities on global temperature levels. But Wildavsky reverses the populist sentiments of doom promoters in arguing:
By what right, one might ask, does anyone enrich himself by enhancing future generations? By what right, it may be asked in return, does anyone impoverish the future by denying it choice? What would you have to believe about the future to sacrifice the present for it? ... The future can acquire new strengths to compensate for old weaknesses, it can repair breakdowns, dampen oscillations, divert difficulties to productive paths ... Fear of the future is manifested by pre-empting in the present what might otherwise be future choices. The future will not be allowed to make mistakes because the present will use up its excess resources in prevention. (p 123)
Risk accompanies our every action but government control and regulation is resource hungry and enterprise sapping. Before we allow these forces to conscript themselves into combating risks, we must be clear on the potential payoff.
APPLYING MARKET SOLUTIONS TO ENVIRONMENTAL GOODS AND SERVICES
THE ROLE OF PROPERTY RIGHTS
Trade and market operations require that property rights be defined and enforced. An important reason for the industrial revolution beginning in England was the security of tenure for private property provided by that country's well developed and independent legal system. Conversely, a significant deterrent to economic growth in many developing countries today is that uncertainty about property rights means that entrepreneurs can have little assurance that they will be able to reap the benefits from investments.
If you make an extra effort in countries with well-defined property rights, you reap benefits. Even those who are less able, or disadvantaged, gain in societies with well-defined property rights -- they are able to benefit from the existence of a more prosperous society, and a society where individuals can create individualistic niches of business opportunity.
Defining property rights has applications capable of maintaining adequate levels of environmental services. Many environmental amenities and services are currently under-valued in market transactions, because they are scarce yet freely available. The best solution to this problem is the extension of markets wherever possible. Many ecological factors and values would be routinely incorporated into economic decisions if property rights to natural resources were to be properly defined and allocated.
Environmental values can be made part of the calculus guiding economic decisions made by private enterprise. Thus, most farmers, although radically transforming the ecology which preceded their activities, already can be said to pay attention to many valued ecological factors in their farm management decisions. Soil nutrients are conserved (and augmented) and measures are taken to prevent soil erosion. The upshot is, of course, about as far removed from any natural ecology as can be imagined, but the rustic ambience of grazing animals and crops meets with most people's standards of a satisfactory environment.
Examples of somewhat manicured "natural" environments produced solely from the stimulus of the profit motive are also to be found in privately owned US forests. In those parts of the US where forest recreational opportunities are not heavily subsidised by governments, firms like the International Paper Corporation employ ecologists to manage their forests to produce hunting, recreation opportunities, bird watching and other environmental services in addition to timber. Also in the US, non-profit organisations like the Nature Conservancy own tracts of forest, some of which are managed to produce timber and mineral output in addition to environmental services. Unfortunately, forest management which pursues multiple purposes like this cannot successfully do so where recreational uses are provided free by government. Such free provision "crowds out" commercial provision, and by providing services without allowing for their alternative uses to be tested by market arbitration. Too many of the free goods are supplied and the community loses by trade-offs being disallowed between some of the free goods and some other goods. Moreover, the free goods are unlikely to be provided as cost-effectively by government as would occur where market disciplines and profit maximisation instil cost-reducing incentives.
Under the legal framework of defined and enforced property rights, so essential to markets, private parties are assigned liability for any effects their activities impose on others. Governments, while often a source of inefficiency when they over-rule mutually beneficial private trades, do have a role in helping the courts define the legal framework; they also have a role in enforcing the decisions of the courts. Governments operate best when they seek only indirectly to foster increasing living standards. It is preferable to leave most of the responsibility for commercial activity to private entrepreneurs acting within the rules laid down by government.
When the legal framework is inappropriate, or poorly defined, standards of living are likely to be compromised. Many "environmental bads", such as pollution, are over-supplied because resources, such as clean air or clean water, are being used without compensation to alternative or potential users of those same resources, such as people wishing to breathe the air, drink the water, or bathe or fish in the streams or oceans. When the air or water is not owned by anyone it is available to those who get in first. Conversely, many "environmental goods", such as the preservation of wildlife or genetic diversity, may be under-supplied because the lack of property rights to these resources limits the net return to entrepreneurs.
In some cases, markets for environmental goods are possible and desirable, yet have not been developed, because governments have been remiss. They have not helped the courts define and enforce property rights over the products or by-products at the heart of the problem. In other cases, difficulties of definition and measurement limit our ability to monitor and control access to resources, yet the "spillover" costs or benefits are significant. In these latter cases there may be net benefits of direct government intervention in resource allocation decisions.
EMPLOYING MARKET FORCES AS REGULATORY INSTRUMENTS
QUASI PROPERTY RIGHTS: TRADEABLE EMISSIONS
Uncertain rights between polluter and pollutee means that air and water pollution are unlikely to be effectively managed by laissez-faire market mechanisms. While there can be "money in muck", the costs of negotiating common law agreements between the parties to emissions or effluent are likely, on most occasions, to be prohibitive.
Excessive levels of pollution may best be combated by the quasi-market solution of defining and allocating trade able pollution quotas; these are alternatives not additions to direct regulations. For direct regulation to be cost effective, governments would need a detailed knowledge of the production technologies and abatement costs of individual firms. In a competitive market it is unlikely that firms will either readily reveal such information or, until obligated by self interest, even seek it out for themselves. In contrast, charges and permits create incentives for individual firms to discover cost efficient means of reducing pollution by reducing output or changing technologies. In this way, Government activity is limited to setting overall targets and monitoring levels of pollution. Unlike direct regulation, governments do not need a detailed knowledge of individual firms' production processes, they simply focus on the defined emissions.
Having defined and enforced a set of effluent quotas, governments should allow the quotas to be bought and sold in an open market. Firms in different industries, or different firms in the same industry, often face radically different marginal costs of reducing pollution output. Those which can reduce pollution output at little cost will have an incentive to sell their effluent quotas, while those which find it very expensive to reduce pollution could purchase additional quotas. The outcome will be a cheaper means of meeting the goals. There will also be some dynamic gains as firms will also face a price for polluting, and they can decide on the appropriate trade-off between investing in pollution reduction and improving the efficiency of other aspects of their production process. Firms which succeed in eliminating pollution can profit relative to competitors who have difficulty meeting the standard. Sorting out just who produces what is then left to the market place, modified only by the governmental imposition of emissions ceilings and tradeable quotas.
There is no valid reason for restricting the purchase of effluent quotas to those who intend to pollute. Nationwide voluntary organisations, such as the Australian Conservation Foundation or the National Trust could purchase quotas and retire them. They could obtain funds from donations, by providing excludable goods such as magazines, naming rights to rivers, scenic reserves, koala enclosures and so on, (1) or from the sale of limited mining or timber rights on their own land. Some corporations might also find that purchasing effluent quotas only to retire them from circulation could be a very effective means of corporate promotion. Once property rights have been defined and enforced and trade in them is facilitated, markets will give large numbers of people a strong incentive to be very imaginative in exploiting any potential gains from trade.
Somewhat paradoxically, limiting access to "environmental services", such as opportunities to harvest or observe wildlife, or the provision of clean air or water, is the key to facilitating markets and thereby ensuring the continued "sustainable" supply of these services. More explicitly, ensuring that environmental services are only provided when something else is given in exchange will guarantee that such services are taken into consideration in market transactions. When goods or services are given away without charge, they are over-used and abused.
For example, cattle and sheep have fared so well as species not only because they are used to provide goods and services in demand but also because they are allowed to be owned and traded. Conversely, it is mainly because it has been illegal to own and trade in elephants, rhinos and some other species in some African countries that numbers have been reduced in order to make way for animals, such as cattle, which can be owned and traded. (2)
While we readily acknowledge that many environmental amenities and services are currently under-valued in market transactions, the best solution to this problem is the extension of markets wherever possible. Where such an extension of markets is impossible, policy interventions should nevertheless harness the power of markets to accumulate and utilise relevant information. This can be accomplished by relying upon tradeable quotas, zoning and covenant restrictions and other similar devices which still allow private ownership and trade.
TAXES, FEES AND CHARGES
Where ownership of rights to pollute cannot be vested, mechanisms involving the use of charging allow some of the flexibility inherent in market operations to be tapped. Such mechanisms have the potential to achieve pollution reduction at a lower cost than direct regulation, as long as they replace the existing command and control measures. If they only become a further addition to a plethora of such regulations, outcomes could, in fact, be worse.
Taxes give decisions about the choice of technology to the private parties. These parties are likely to be both better informed about relevant choices and more highly motivated to select the most cost effective choice than government officials. Taxes and charges are less flexible than vesting of tradeable rights because they do not allow economies to be made by those able to make them most cheaply. With perfect information on firms' abatement costs, it is possible that charging mechanisms and tradeable rights would yield equivalent outcomes as illustrated in Chart 2.1.
The chart assumes an independently determined level of output. Reductions in effluents and emissions are achieved by employing different technologies to produce this same output. The two intersecting curves represent the marginal costs of abatement (MCA) for two firms with differing reduction costs. MCAs tend to increase with each successive unit of effluent or emission reduction. Consequently the curves are drawn as exponentially increasing functions of the level of pollution reduction. The X axis shows these levels in units of concentration such as parts per million. However, for the high cost firm the axis is read from right to left, as opposed to the low cost firm which reads in the more conventional manner from left to right. The total length of the X axis is set equal to the required level of reduction -- in this case 10 units of concentration. The Y axis measures abatement costs.
Constructed in this fashion, the chart shows the abatement costs incurred by both firms for every possible combination which achieves the desired total reductions. For example, if a uniform standard is set at s, so that both firms have to reduce emissions by five units, then the abatement cost of the high cost firm will be b, and those for the low cost firm will be a. The efficient combination of reductions is e, where the marginal costs of abatement for each firm are equal. At this point the total abatement costs are at a minimum. The low cost firm reduces emissions by seven and a half units, while the high cost firm only reduces by two and a half units. Compared to this cost effective solution, the uniform standards imposes an extra cost on society equal to the shaded area. Regulatory standards could be varied but this would require knowledge of the individual firm's abatement costs which would be difficult and costly to obtain especially when the analysis is extended to more than two firms.
Chart 2.1: Taxes and tradeable permits compared with a uniform standard
Source: Based on Tietenberg (1988)
One alternative to attempting to individually calculate the MAC curves of every firm, is to impose a tax on each unit of emission. After being first imposed at an arbitrary level, it would be gradually adjusted up or down until the desired level of reductions is achieved. Under the tax, governments would not require a knowledge of abatement costs but would need only to monitor emissions. As long as the tax is higher than marginal abatement costs, each firm has an incentive to reduce emissions. Once marginal abatement costs are equivalent to the tax paid on each unit, firms will choose to pay the tax rather than reduce emissions further. In Chart 2.1, t represents a tax of say 10 cents per unit of concentration. At this rate the high cost firm will reduce emissions by two units and the low cost firm by eight units. The tax achieves the desired level of abatement at the cost effective point e. Discovering the correct rate would require an interactive monitoring process but not the detailed knowledge necessitated by standards.
Tradeable permits represent an even more effective means of discovering the most cost efficient combination of reductions. Tradeable permits do not require an interactive process to search out the correct level of reductions. Instead, the total level is fixed from the outset at 10 units lower than current levels. Only permits up to this level are issued. The initial allocation could be the same as a uniform standard but firms would now be able to trade their pollution rights. Referring again to Chart 2.1 the high cost firm will be willing to buy its first additional permit for emitting one unit of concentration as long as the price is lower than its abatement cost b. The low cost firm is willing to sell as long as the price it receives is higher than its abatement cost a. Both firms would benefit by trading at least one permit and, by like reasoning, they would also benefit by trading all their permits between s and e. If this trade is allowed to occur the efficient solution will once again be achieved. The advantage is that the level of reduction could be determined from the outset.
Other advantages associated with tradeable permits are that the level of reduction would remain constant over time as no additional permits are issued. In contrast, taxes would constantly need to be adjusted as population, and economic growth increased emission levels, and inflation devalues the tax.
The analysis so far has assumed that individual firms themselves know their marginal costs of abatement and the effectiveness of their abatement strategies. Baumol and Oates (1988) and others have pointed out that, if there is uncertainty about marginal costs, and risks associated with either exceeding permit levels or over achieving reductions, then permits will not provide the most cost effective solutions. Nevertheless, the uncertainty of outcome associated with taxes, and the clear costs associated with uniform standards, make a strong case for favouring tradeable permits.
Informational uncertainties aside, the conditions under which taxes and tradeable emissions could in theory be equivalent are very restricted. Taxes can only be equivalent to tradeable permits where the supply curve is fixed, a textbook fantasy in most industries.
WHEN DOING NOTHING IS THE PREFERRED SOLUTION
In many cases, both the costs of either defining and enforcing property rights and establishing the alternative regulatory processes, or the administrative costs of market mechanisms will turn out to exceed the net benefits of ensuring that all "spillover" costs and benefits are accounted for. If the "spillover" costs or benefits are not large in such situations, the best we can do is ignore them. This was explored some time ago in a seminal article by the economist Ronald Coase (1960). He notes:
There is, of course, a further alternative, which is to do nothing about the problem at all. And given the costs involved in solving the problem by regulations issued by the governmental administrative machine will often be heavy ... actions which give rise to harmful effects will be less than the costs involved in government regulation. (Coase, 1960:18)
Similarly, when discussing the use of the common law to handle externalities, Coase notes:
the reason why some activities are not the subject of contracts is exactly the same as the reason why some contracts are commonly unsatisfactory -- it would cost too much to put the matter right. (Coase, 1960:39)
The key point of Coase's article is that there may be adverse consequences for efficiency if legal rights are assigned when transactions costs are not trivial.
In earlier sections, when addressing the vesting of transferable rights to pollute, it was argued that such a re-arrangement would lead to an increase in the value of production. But this assumed costless market transactions. Once the costs of carrying out market transactions are taken into account, it is clear that such an allocation of rights will only be worthwhile when the increase in the value of production consequent upon the allocation is greater than the costs which would be involved as a result of it being brought about.
In these conditions the initial delineation of legal rights does have an effect on the efficiency with which the economic system operates.
Coase argued that "the ordinary law of nuisance" is likely to take these transactions costs into account and, that in order to maximise efficiency, we should assign the legal rights to one party in some circumstances and to the other party in other circumstances.
In yet other cases, the legal rights might be assigned to one party or the other by default, since an unambiguous assignment avoids the legal costs of deciding a particular case on its merits. For example, an individual might find his neighbour's garden to be incredibly ugly, but costs of determining the "psychological harm" inflicted by a distasteful garden versus the "psychological benefit" accruing to the owner of the garden from planting it how he likes, are likely to be quite large; a court would most likely decide that the costs exceed the net benefits from forcing owners of gardens to take their neighbours' preferences into account. From a legal perspective, such a judgement would rest upon the preponderance of the property rights involved. As a general rule, the owner of the garden would have the right to plant however he likes. If the decision were to favour the complainant, we would no doubt experience a rash of frivolous law suits as people acted in response to perceived deficiencies of their neighbour's gardens. The costs of litigation would, in general, exceed the benefits resulting from home owners taking account of their neighbours' preferences when managing their gardens. Ignoring the externalities will generally be the preferable approach to many such cases.
Transactions costs, or the costs of defining and enforcing property rights, include the costs of monitoring and measuring consumption or use, and the costs of negotiation and, perhaps, litigation. Monitoring costs are not frozen but will change, sometimes rising (where they rely on skilled labour inputs, for example) but more often falling as technological solutions are devised. Indeed, developments such as the silicon chip and video scanning are making it progressively easier to verify and measure actions. Moreover, private ownership of property creates incentives to devise privately profitable new ways of monitoring access and use of that property. For example, privately owned cattle herds grazing on vast acres of privately owned or controlled land created a market opportunity for the invention of barbed wire. This greatly reduced the costs of monitoring cattle, enabling increased scope for improving grazing land as other "free riding" farmers and wild animals could be excluded from the benefits. Similarly, the electronic monitoring of vehicles which choose fast lanes, and the scope for computerised monitoring of car emissions across freeway entrances or other locations, have the possibility of internalising many costs drivers and cars impose on others. (3)
Negotiation costs are a further element of transaction costs. These include the time and effort involved in reaching mutually acceptable agreements and can involve the costs of lawyers, accountants and specialist brokers. The extent of formality in the negotiations, and therefore the costs involved, will depend on the number of parties to the transaction, and may be quite sensitive to how well the parties know each other. The costs will also depend on the legal precedents which have been established. If past judgements are clearly applicable to a current case, it is unlikely that the dispute would proceed to litigation. All parties could be confident of the decision the courts would reach were the dispute to be litigated and they would have a large incentive to avoid unnecessary legal costs.
Low benefits from defining property rights can also imply that the situation is best left alone. But again this situation is not immutable. Some sources of pollution, for example, may have been of less concern in the past partly because most environments are able to cope with small amounts of pollutants without serious consequences. This would suggest that it has become efficient to control pollution only as the amount of pollution has risen. Similarly, the demands for clean air and water, and recreation opportunities, probably have increased along with increased standards of living, and this has also raised the benefits of defining property rights to many environmental amenities.
REFERENCES
Bernstam, M.S. (1989) "Productivity of Resources, Economic Systems Population and the Environment": Is the Invisible Hand Too Short or Crippled?, Centre of Policy Studies, Monash University. To be included in Davis, K. and Bernstam, M.S. (1990) (eds.) "The Endless Frontier and Resources", Cambridge Univ. Press, New York.
Boyet, W.E. and Tolley, G.S. (1966) "Recreational Projections Based on Demand Analysis", Journal of Farm Economics, 48(4).
Coase, R. (l960) "The problem of social cost:, Journal of Law and Economics, 3: 1-44.
Krutilla, J.V. and Fisher, A.C. (1985) The Economics of Natural Environments: Studies in the Valuation of Commodity and Amenity Resources, Washington DC: Resources For the Future.
Pearce, D., Markandya, A., Barbier, E.B. (1989) Blueprint for a Green Economy, London: Earthscan Publications.
Pearce, D. (1980) "The Social Incidence of Environmental Costs and Benefits", Progress in Environmental Planning and Resource Management, 2.
Sowell, T. (1987) A Conflict of Visions, New York: William Morrow and Company Inc.
Wildavsky, A., "No Risk is the Highest Risk of All", in Clickman, T.S. and Bough, M., Readings in Risk, Washington DC: Resources For the Future, 120-128.
ENDNOTES
1. Many of these natural and man-made sites are now named after politicians, the royalty or historical figures. They are marketable services, however, which could be used to raise funds, much as private universities in the US raise funds by selling naming rights to buildings and so forth.
2. In some cases, even if it were legal to own and trade in wildlife, the value of the wildlife might be less than the value of cattle so numbers might still be reduced to make way for additional cattle. We would expect, however, that as the numbers of wildlife species fell their relative value would rise. Many of the wildlife species probably also would be less expensive to farm since they are most likely better adapted to the local ecosystems. Thus, they may be chosen in preference to cattle even if their market value is somewhat less.
3. These technologies are not just pipe-dreams. Electronic toll and traffic management systems were implemented on a New Orleans toll bridge in June 1989, the Alesind Tunnel in Norway in 1987, and a number of other Norwegian, French and Italian tollways. The systems involve a small electronic card attached to your car which can be detected by a laser monitor. Extending the scope of the systems to include conjection pricing and pollution control are technologically viable possibilities. Robert E. Poole (1990) Electronic Toll Collection -- Key to Solving Urban Freeway Congestion, Santa Monica, CA, Reason Foundation.
