Introduction:

Most health and safety regulations are designed to overcome problems of asymmetric information.  Most environmental regulations are designed to overcome the problem of negative externalities.  These may be thought of as types of social regulation.

Social regulation refers to the regulation of economic behavior to advance social goals in circumstances in which neither competition nor economic regulation are expected to work.

We will consider:
(1) The market failures that social regulation addresses
(2) The effectiveness of different types of social regulation in addressing these market failures.

1. The economics of pollution control

Pollution is a negative externality.

Pollution arises as a consequence of production and consumption – both activities generate “bads”.

For example, factories often release particulate matter into the air to produce a good or service, households produce garbage as they consume goods and services.

a. The economic rationale for regulating pollution

When firms use resources that they do not consider to be scarce, they don’t consider the cost of those resources.

When firms pollute they are failing to recognize the scarcity of a resource – a clean environment.

Example: A paper mill discharges effluent into a river which hurts the fisherman who fish downstream of the paper mill.  The profit maximizing paper mill neglects the external effects of its production because its profits are not directly affected by them.

The principle of allocative efficiency requires that the price of a product (the value that consumers place on the marginal unit of output) should be equal to the marginal social cost (the value of resources that society gives up to produce the marginal unit of output).

In the presence of negative externalities the marginal social cost (MSC) and marginal private costs (MPC) diverge, because the firm does not face the costs of the pollution it creates.

The firm produces where P=MC, which ignores the externality and results in too much output.

Diagram (insert here):
 

The price that consumers pay for the product covers the marginal private cost of its production but not the external costs.  At that level of output, the MSC is greater than the MSB (marginal social benefit) and the firm should reduce its output to the level where MSC = MSB.

MSC=MSB is the allocatively efficient level of output.
This is also called the socially optimal level of output.  It is the quantity where all the marginal costs (private plus external) equal the marginal benefit to society.

Making the firm bear the entire social cost of its production is called internalizing the externality.

If external costs can be accurately measured, forcing the firm to internalize them can lead to the socially optimal level of output.

b. Pollution control policies

The optimal level of output for society is generally not the level at which there is no pollution.

Zero environmental damage is generally not economically efficient.

The government must therefore determine what the optimal level of pollution control is.  The analysis involves determining what level of pollution control will maximize social welfare.

Diagram (insert here):

What is the optimal amount of pollution abatement or pollution control?

There are MSB from pollution abatement.  We can think of the MSB curve as the demand curve for pollution abatement.  The curve slopes downward because starting at non-lethal levels of pollution, people will derive some benefit from reducing the level of pollution, but the MB from each reduction in pollution will be lower, the lower the level of pollution.  There is an opportunity cost of putting more and more resources into cleaning up the environment – when the environment is very dirty, the MB of reducing pollution is high, when the environment is very clean, the MB of reducing pollution is low.

There is a MSC of pollution abatement.  This is like a supply curve for pollution abatement.  The MSC will tend to be low for low levels of pollution abatement and will rise sharply after some point.  For each firm that pollutes, there will be some action that can be taken fairly easily and reducing pollution will be relatively cheap compared with further reductions.  It is also the case that pollution reduction will be easier for some firms than for others such that once the firms who can reduce pollution easily have done so, the cost of further reduction in pollution will rise.

Specific policies:

(1) Direct controls

These are the most frequently used type of environmental regulation.

Direct controls impose a standard that has to be met either in terms of (a) the prohibition of certain behaviors, (b) the use of a particular device to reduce pollution, or (c) a limit on the amount of pollution created.

Q. Can you think of examples of these types of direct controls?

What are the problems with direct controls?

i. They tend to be economically inefficient

· They fail to recognize that polluters face different costs in reducing pollution.  Therefore, they do not minimize the costs of a given amount of pollution abatement.
· In the case where they mandate a certain pollution control device be used, they may discourage innovation in coming up with more cost effective ways of reducing pollution

ii. They tend to be costly to monitor and enforce.

(2) Emissions Taxes

The government may levy a tax on emissions at their source.  A firm will have to pay a tax t per unit of pollution it emits.

Such taxes can internalize an externality such that the allocatively efficient level of output can be produced.
If the government sets the tax equal to the firm’s MB of pollution reduction then profit maximization will reduce emissions to the point where the MC of further reduction is equal to t.

Diagrams (insert here):

Emissions taxes have the advantage that they can minimize the cost of reducing pollution.

They also have the advantage that regulators don’t need to specify how the pollution is to be abated – that is left to the individual firm.  The profit motive will lead them to find the lowest cost method of pollution abatement.

Problems with emissions taxes:

i. They only work if it is possible to measure emissions accurately.

ii. They are not effective when it is necessary to ban an activity completely.

iii. In practice it is difficult to set the tax rate at the optimal level.

iv. It is not possible to control pollution in the area of a specific firm – if the firm has a high cost of pollution control, it will pay the tax and continue to pollute.

(3) Tradeable emissions permits

Tradeable emissions permits are “rights to pollute”.  Typically rights to pollute a certain amount are auctioned off to the highest bidder.  It is typically firms with the highest costs of reducing pollution that buy up the rights to pollute.

In essence a market in pollution rights is created.

Tradeable emissions permits can combine an advantage of direct controls (setting of a standard to limit the total quantity of pollution) with an advantage of emissions taxes (allowing firms to find the lowest cost methods of reducing pollution).

Tradeable emissions permits can achieve the same outcome as emissions taxes but their great advantage is that they don’t require as much information.  Regulators don’t need to set the optimal tax rate – all they need to do is determine the optimal amount of pollution abatement.

Many people like the idea of tradeable emissions permits because they represent what is effectively a market solution to a market failure.

Q. Why do some environmental groups really like the idea of these permits?

Problems with tradeable emissions permits?

i. There are costs of monitoring and enforcement similar to those with direct controls.

ii. It isn’t possible to reduce pollution in the area of any specific firm – it the firm has a high cost of reducing pollution it will buy a permit and continue to produce pollution.

2. Regulation for health and safety

In the US:
· The Food and Drug Administration (FDA) must approve the marketing of prescription and non-prescription drugs.
· The National Highway Transportation Safety Administration (NHTSA) regulates the features that automobiles must have, such as brake lights and seat belts.
· The Consumer Product Safety Commission (CPSC) regulates goods in the market place.
· The Occupational Safety and Health Administration (OSHA) regulates the workplace in terms of health and safety of workers.
· The Federal Trade Commission (FTC) regulates “truth in advertising”.

All of the above are regulatory agencies that address the market failures caused by asymmetric information.

a. Information as a public good

The public good nature of information is: since information once available can be easily shared and widely distributed, it is impossible for a firm to recoup its investment in producing information, and too little information will be produced in the market.

If certain types of information about product safety and safety int eh workplace are considered public goods, there is an economic rational for the government to intervene in the market to produce that information.

b. Is good information enough?

Most regulation goes beyond the provision of information.  The government typically imposes standards that firms are required to meet.  This involves monitoring and enforcement costs on the part of regulators.

In theory, the provision of perfect information such lead the market to the allocatively efficient outcome.

In practice there are two arguments for government intervention:

i. Imperfect information:

Perfect information may be impossible to obtain or evaluate.

Safety standards can free workers and consumers from the task of trying to make difficult calculations they are ill-equipped to make.  In this case, standards can increase efficiency.

ii. Paternalism

We may want to protect people from themselves or from others.

Examples of paternalism in regulations:
o Seat belts
o Child car seats
o Non-flammable sleepwear for children

c. Health and safety regulation in practice

Government often works with imperfect information and as such some of the decisions that they make may not be good ones.  There is a trade-off between doing something and not doing anything and no simple answer exists to how the government can be more effective in setting social regulations.

3. Cost-benefit Analysis of social regulation

The benefits of social regulation are fairly clear – people benefit from not being subjected to unsafe goods, unsafe workplaces and a polluted environment.

To determine the optimal amount of social regulation we need to consider the costs of providing it.

Economists will argue that the optimal amount of social regulation exists where the MSB of the regulation is equal to the MSC of the regulation.

Diagram (insert here):

One of the criticisms of this approach is that economists fail to acknowledge how difficult it is to measure the costs and benefits of social regulation.

A second-best analysis that is often undertaken is called Cost Effectiveness Analysis.  It is easier to perform that CBA.  In this analysis the policy maker holds a certain output of a policy constant, then looks for the cheapest or most cost effective way of pursuing those outputs.

4. Principles of regulatory reform

Read pages 420-421.