1.3 Environmental economics and the role of environmental regulation in free markets

This is a text about science, but applied science is often used to create environmental regulations, and environmental regulations are often needed to protect environmental health. Nevertheless, environmental regulations are often subject to attack by people who believe they are an economic mistake that burdens businesses and raises prices for consumers.

Many thanks to Professor Ken Richards of the O’Neill School of Public and Environmental Affairs at Indiana University-Bloomington for his care and thoroughness in the review of section 1.3.

A free market exists when people can freely choose what they want to buy or sell and can pay or receive a fair price for it. In a free market, all goods and services are privately owned; the benefits and costs of the goods and provision of service are received (benefits) and borne (costs) only by the owners of the goods or the providers of the services, who can protect their ownership (theft can be prevented). Consumers have enough information to know whether they want to pay the offered price, and there is competition among providers.

Adam Smith, a Scottish economist and philosopher, wrote An Inquiry into the Nature and Causes of the Wealth of Nations (often shown just as The Wealth of Nations) in 1776, just as the US was becoming a nation. In it, he suggested that individuals acting only for their own self-interest in buying and selling could still benefit society at large. He suggested that free markets were one way this could happen (economists these days also call them perfectly competitive markets). Economists maintain that true free markets – free markets that meet all the requirements to be called free markets – result in a situation in which everyone in the market is as well off as they can be, without hurting others, without outside regulation.

Note that the prices that result from a free market are not the same as low prices, or convenient prices. Rather, they are prices that accurately reflect the cost of the good or services that consumers are willing to pay and that owners are willing to offer. If the owner sets the price too high, consumers will have enough information to understand that the prices is higher than they need to pay, and there will be competitors to offer lower prices, but only to the point that owners can still make the profits they need in order to continue to produce the items involved. Prices, in the long run, will support the continued existence of owners, who invest money to provide the goods and services, but will not rise far above that point for long, because competition will bring them back down. Owners are driven to be efficient in their production of goods and services, so that they may become cheaper over time and consumers that make themselves aware of alternative prices can benefit from that increased efficiency. If a good or service is rare or difficult to provide, then owners will only be able to ask higher prices if the item is attractive enough that consumers will pay high prices, and consumers will understand the situation well enough to choose whether to pay high prices.

This theoretical ability of free markets to self-regulate is very attractive to those who dislike the idea of government regulation, and when it works, it is a very efficient means of setting prices that benefit all parties in the market to the extent possible.

Requirements for free-market conditions

As in all good stories, the devil is in the details. Let’s look first at the requirement for private ownership of goods and services. Economists term this universality because, in a free market, all goods are privately owned.

Not all goods and services are privately owned: private, public, club, and common-pool resources

Economists divide goods (things, mostly) into categories depending on whether there is competition for their use (usually, no one competes for air, but lots of people compete for trees that produce expensive timber), and whether or not it’s possible to prevent people from accessing the goods (not really, for air; possibly, but not always, for the trees). Figure 1 shows the formal names given to the resulting categories. If access to the resource can be controlled, it is considered excludable; otherwise, as for many natural resources, it is non-excludable. If competition occurs, the resource is considered rivalrous. In the absence of some system of governance, most natural resources are non-excludable and rivalrous and are therefore considered to be common-pool resources. Because air is non-excludable but not a resource for which there is competition, it is classified as a public good.

Some of the boundaries between categories can become blurry under some circumstances. Public, non-toll roads are typically considered to be public goods for which people do not compete. Taxes pay for the roads and everyone can use them. But any city at rush hour demonstrates that, if there isn’t competition, precisely, easy access is certainly not available! Economists use the term congestible for this halfway situation. Managers of popular public parks may monitor user numbers and close a park (if access can be controlled) if user numbers become too high for safety, resource protection, or enjoyment.

Many natural resources are common-pool resources. There is competition for access, use, and consumption and, depending on the relevant legal system, they are not owned or controlled, and as a result do not qualify as ideal free markets. Wildlife, timber, ocean resources, and fresh water are often examples. Because access is not controlled, the distribution of benefits and harms that accompany access is not controlled, and overuse or overharvest are likely to occur – deforestation, extinction, water pollution, etc. Both the resource and the public may suffer harm as a result. The phrase Tragedy of the Commons is used to describe the results of easy access to a resource no one protects.

Regulations can confer legal ownership for some common-pool resources (mining laws, for example, allow miners to own the minerals they recover), and can regulate to prevent harm, without mimicking private ownership, in others (air pollution laws, for example, in which a government takes stewardship of the air resource). Only the first case – mimicking private ownership – seeks to create something like a free market that can provide the benefits of protection of the resource that free markets can offer. So-called extractive resources – resources that are removed in order to use or consume them – are often good candidates for legal ownership. Laws often convey legal ownership of timber, plants, minerals, and water but may vary in how well they achieve the conditions of free markets and sustainability of the resource (for renewable resources).

Not all natural resources are easily protected by these mechanisms. Ocean fisheries provide an example of complexity. By international law, nations control the seas within 200 km of their borders (their exclusive economic zones – EEZs), and can regulate fishing in EEZs, conveying legal ownership of fish to allow commerce and a market. Nations each have their own systems, and some create more sustainable conditions than others. But no international law conveys ownership-like status in the open ocean. Fish that only inhabit the open ocean and fish that migrate across EEZs and the open ocean can be protected by international treaties among nations but not all nations sign such treaties, monitoring can be difficult or impossible, and enforcement requires willing and cooperative partners. As a result, sustainable management of ocean fisheries is still very much a work in progress. Minerals from the deep ocean floor are a common-pool resource for which treaty discussions are currently very dynamic.

Some aspects of freshwater make it difficult to create something approaching free-market conditions. The ability to withdraw water for industrial, municipal, agricultural, and household use is often legally controlled, but these laws may run into problems dealing with surface water and ground water, because these are often more closely connected than the laws recognize. Access to swim or boat on water may be controlled by a property owner for a pond or lake entirely within a single property, but may be more complicated if multiple property owners, towns, states, or nations are involved. Access to discharge pollution into water is similarly complicated by jurisdictional issues. Pollution that enters the water at one point can spread to other points that may not have jurisdiction to prevent the pollution at the source. National regulations and international treaties can used to control the problem, but, as with oceans, bad actors – from individuals to nations – can degrade and diminish these shared-access resources. Water-pollution laws are most often permit/penalty systems, rather than systems that involve markets.

Because air is not usually subject to competition, and is not excludable, it is considered a public good. Air pollution can be limited through regulations of the sources of air pollution, but air pollution, like water pollution, can cross jurisdictional lines. National-level regulation can maintain air quality within a nation, but international treaties are needed to maintain air quality when air pollution cross international lines. Market-based mechanisms called cap-and-trade agreements exist for some air pollutants, notably the main precursors for acid rain – sulfur dioxide and NOx – and carbon in the form of CO₂ equivalents. These create a market for air pollution, and regulations seek to approximate a free market. In other cases, laws are directly regulatory – like water-pollution laws – setting limits and imposing penalties, so no market conditions exist.

As you can see, the free-market requirement for universality – private ownership of all goods and services – is not so universal. Now let’s look at exclusivity.

Externalities are failures in the exclusivity of costs and benefits to owners

Under theoretical free-market conditions, all the benefits of having a good or providing a service accrue exclusively to the owner, and all the costs of creating the good or providing the service likewise are borne by the owner. This characteristic is termed exclusivity. In the real world, things are often not so neat.

Even with something as simple as a shirt or a can of peas, pollution from fabric dyes or erosion from agriculture may enter air or water, creating a burden borne by members of the public, whose taxes often pay for pollution monitoring and enforcement. If regulations recoup the cost through permitting fees and penalties, then the public is made whole and does not pay to clean up after the private owners. But often, this is not the case. Monitoring may not occur at all, or may have gaps in coverage. Enforcement may be understaffed. Regulations may not exist in the first place, so that neither monitoring nor enforcement exists. Then the public bears the costs of these unintended but unavoidable results of industry and agriculture in harm to themselves and their property, and in harm to the common-pool and public resources on which they rely.

An externality is a cost or benefit that arises as a result of provision of a good or service but is not received by or borne by the owner. The problems with shirt and pea production in the previous paragraph are negative externalities.

Not all externalities are negative. If your neighbors keep beautiful homes and lovely gardens, your property values may rise, as a result, providing you with a positive externality. If one property owner along a lake restores shoreline wetlands that improve water quality, all users of the lake benefit.

Externalities result from the production and consumption of many private goods and services, but are particularly likely to exist when natural resources are harvested or extracted, because of the complicated connections among the components of the natural world. The hunter who kills a wolf in a legal hunt affects the deer populations in the area, which in turn affects the vegetation, which may affect timber availability and soil health. The logger who extracts timber from a forest may create erosion that affects water quality; reduce water filtration at the harvest site; and alter the composition of wildlife, fish, and plants in the vicinity. In theory, externalities can be prevented (or at least mitigated) by laws that protect environmental health, but legal protection and enforcement are often incomplete, and externalities are common, as a result.

The real world is not doing well so far with universality or exclusivity. On to perfect information.

Perfect information is rarely available

Because information about externalities is often unavailable, consumers cannot always make informed decisions about what to purchase from whom, which also defeats the requirement for so-called perfect information in a free market. Non-economists can be forgiven for assuming that perfect information is the same as complete information, but consumers don’t need to know absolutely everything about goods in order to make informed decisions. We probably don’t need to know the color of the walls in the office of the plant in which the peas are canned, for example. But consumers may want a wide range of information about environmental, economic, and societal impacts before they decide what to purchase, and from whom. Information can be required by law, but often is not, and enforcement of requirements to provide accurate information may also be insufficient.

The real world often fails to meet major requirements for free markets, as we have seen. Environmental regulations can help.

Environmental regulations are often required t o meet free-market conditions

A common accusation levelled against environmental regulations and regulators is that they are interfering with free markets. People often know that free markets can operate “without regulation,” but often do not know about the many requirements that must be met in order for a free market to exist in the first place.

Common-pool resources, theft and poaching, externalities, lack of information, and monopolies all defeat free markets, and all can be addressed, if imperfectly, through regulation. Thus, environmental regulations can be necessary to mimic free-market conditions for goods and services that are not private. Without such protections, the public is left with the cost of cleaning up environmental harm or is deprived of opportunities and services that cannot be replaced.

Costs for clean-up and loss of ecosystem service are separate from the costs of shirts and peas and timber and fish. As a result, people may not see the link between the low cost of timber or a shirt and the high price for drinking water or the loss of wildlife. One phrase used in environmental activism that makes this link more visible is “polluter pays.” But when harm is not as obvious as dirty air or water, it may still be hard for people to see connections between environmental regulation, environmental health, and efficient prices for goods and services.

Not all regulations support free-market conditions. Some regulations are created for other purposes, such as tariffs that are used for political reasons. But even regulations designed to support free-market conditions may be imperfect. For example, laws may impose weak penalties that fail to protect resources, public health, etc. The process of creating environmental regulations thus requires firm foundations in both environmental science and environmental economics.

Free markets do not ensure sustainable use of traded resources

Obviously, consumable, non-renewable resources such as oil cannot be used sustainably because the processes that create oil in nature are much slower than the processes that use oil and convert it to CO₂ and H₂O. So, a market in oil cannot achieve sustainability. But markets are designed for buying, selling, and trading, without any dilution by other aims such as sustainability. For example, laws usually allow buyers to legally own wood. If wood from a particular tree becomes very attractive to buyers, and sellers believe the attraction will be short-lived, then the market may exhaust the available supply of timber, or even, in a worst case, cause the extinction of the tree species, if buyers and sellers are willing to do so. Often, sellers are invested in continuing to provide goods and services and buyers are opposed to extinction, which can support conservation measures if everyone is aware of a risk of extinction due to trade. Where such interests are not strong enough, if society has an interest in avoiding unsustainable use or extinction, then other kinds of regulations are needed to identify at-risk species and halt trade before extinction occurs.  One such regulation is the international treaty known as the Convention on International Trade in Endangered Species, or CITES.

Knowledge Check:

This section introduced several new vocabulary terms. Use the interactive activity below to test how many you can recognize after just one read-through. If you miss a question, don’t worry – return to the section to review the word and better understand its meaning.