Business Environment


Our discussions have led to two conclusions:
  • unregulated market behaviour may fail to produce socially efficient outcomes in the presence of externalities;
  • direct bargaining can lead to efficient outcomes, but is unlikely to be feasible where externalities take the form of significant effects on the natural environment.

Can public policy provide a framework within which efficiency gains are achievable? An affirmative answer can be given to this question. In order to achieve efficiency gains, public policy should be directed so that either
  • firms are prohibited from doing things the social costs of which exceed the social benefits, or
  • firms should be given incentives to not do things for which the social costs exceed the social benefits.

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Quantitative regulations

Quantitative regulations, often labelled as “command-and-control” measures, operate by establishing standards or limits that producers or consumers must comply with. They typically lay down maximum amounts of specified pollutants that can be emitted in given periods of time, or require that some index of pollution-concentration be kept below a prescribed limit. In extreme cases, regulations prohibit the use highly damaging inputs, or require that a pollutant emission be zero.

Alternatively, regulations may require the use of particular “clean” technologies in some production processes. In motor vehicle production, mandatory technology regulations are used widely. These include emissions standards for engine units of given sizes and for particulate emissions from diesel engines, and requirements that manufactures install catalytic converters produce engines that are operable using unleaded fuel. Standards-based approaches to pollution control have been (and remain) the main component of control programmes in the United States and Europe.

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Incentive schemes operate by providing monetary inducements to firms or consumers to behave in ways that are thought to be socially desirable. The most straightforward example is a pollution tax. Recall the example of a chemical industry producing a harmful pollutant. What happens if a pollution tax, equal to the monetary value of the damage done by an additional unit of the pollutant, is levied on producers for each unit of emissions?Tax Pollution, Not Income: A New Prosperity in an Ecological Age (Directions for a New Millennium, Volume 1)

To deduce the consequences of this pollution tax, refer back to Figure 13.4. For simplicity, we suppose that the ration of output to pollution ratio is constant. The horizontal axis can then be read either in units of pollution or in units of chemicals output. The tax is levied at  per unit of pollution, the monetary value of a marginal unit of pollution. This increases post-tax production costs; the marginal cost schedule is raised from PMC to SMC. The externality has been ‘internalised’ into the firms’ cost schedules.

Two consequences follow:

*The firms in the industry will now choose to produce Q2, the socially efficient output.
*As producers bear pollution costs, they have a continuous incentive to reduce the pollution. Firms will invest in pollution abatement as long as the cost is less than the tax avoided. This is exactly what economic efficiency requires.

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Pollution targets can also be attained using pollution abatement subsidies. A subsidy is a negative tax, so the incentive effects on firms already in the industry will be the same whether a subsidy of is given for each unit of pollution abated or a tax at the rate is levied on each unit of pollution emitted. The short term effects on emissions levels are identical.

The long run effects of taxes and subsidies are likely to be very different, however. This is because their income effects are different. Pollution taxes reduce the profitability of the affected industry, whereas subsidies increase profitability. Subsidies might, therefore encourage entry into the industry, decreasing the effectiveness of the control programme. The opposite effect will follow from tax schemes. 

When subsidies for pollution abatement increase total emissions.: An article from: Southern Economic Journal

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A third type of incentive based pollution control scheme involves the use of marketable emissions permits (Marketable emission permits – an approach to managing ag impact? (conference on agricultural conservation policies): An article from: Journal of Soil and Water Conservation). In order to implement a system of pollution control using marketable permits, the control authority must
  1. decide how much of the relevant type of pollution is to be allowed;
  2. print sufficient emissions permits so firms may pollute up to the total allowable limit;
  3. sell, or distribute in some other way, the emissions permits to potential polluters;
  4. guarantee that emission permits can be traded between firms;
  5. subject any firm to a prohibitively expensive fine for any pollution it generates in excess of the amount allowed by the permits it possesses;
  6. monitor the operation of the scheme, periodically changing the total allowable amount of pollution as conditions change.
At first site, this system might appear to be no different from the use of simple quantitative controls. But there is one major difference: the permits can be exchanged between firms. The consequences of this are very important, as we shall see in a moment.
How are the permits initially allocated? One method involves giving them to firms, either in proportion to firm size or to the level of their current emissions. A second method involves auctioning of permits. Whatever method is chosen, the same total quantity of permits issued is identical. So the effect on pollution is unaffected by how this initial allocation is made.
What makes this scheme so interesting is what happens next. A market will develop in the transferable permits. Some firms are willing to pay large amounts for permits, others only small sums. In the course of trading, a single market price will emerge. The firms which purchase permits are those willing to pay at least the market price. For them, pollution abatement is expensive and they prefer to buy permits rather than to pay large sums to reduce pollution. On the other hand, those firms which sell permits are those for whom the value of using a permit is less than the market price; these will be firms in which pollution abatement is relatively cheap, and so will prefer to pay to abate pollution, and more than cover these costs by the proceeds from selling permits.
It is this process of trading that leads to the efficiency property of a transferable permit system. The pollution abatement effort becomes concentrated in the hands of those firms which can do it most cheaply. Permits to pollute become concentrated in the hands of firms which have the highest pollution abatement costs. In this way, the total cost of achieving any pollution reduction target is minimised.

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Taxes, subsidies and marketable permits are each cost-effective: they achieve any chosen pollution target at the lowest possible cost. We have already explained why this is so for marketable permits. The reason why it is also true for taxes (and subsidies) is very simple. For any given tax (or subsidy) rate, firms will reduce pollution whenever the cost of doing so is less than the tax they would have to pay (or the subsidy they would lose) on additional units of pollution. The end result is that most pollution abatement is done by firms for whom it is cheap to abate, and least is done by those for whom abatement costs are the highest. Transferable permits, pollution taxes and pollution abatement subsidy are equivalent ways of achieving the same goal, and each attains the goal at the lowest cost. Furthermore, each of these three instruments has desirable incentives. Reducing pollution increases a firm’s income, and so an ever-present incentive exists to develop low-cost methods of reducing pollution.

Economists have two main criticisms of command-and-control instruments. First, they fail to create appropriate incentives. Once a target has been achieved, no incentive exists to search for low cost ways of reducing pollution further. Second, they are not cost-effective. Typically the same degree of control is placed on firms irrespective of how costly it is to reach that target. Cost efficiency is squandered by not focusing control where the costs of doing so are lowest.

In assessing the performance of the marketable emissions permit schemes in the United States in comparison with the older command-and-control approaches, Tom Tietenberg has written

[marketable emissions permits] programme has unquestionably and substantially reduced the costs of complying with the Clean Air Act. Most estimates place the accumulated capital savings for all components of the programme at over $10 billion. This does not include the recurrent savings in operating costs.

(Tietenberg – Environmental Economics and Policy (5th Edition), 2006, page 269-270 in the Markandya and Richardson reprint).

These cost savings accrue to polluting firms and to the economy as a whole. If firms are to be controlled, it is clearly desirable that the cost is as low as possible. Many kinds of command-and-control regulation give firms little or no flexibility in how they are to be achieve targets. This lack of flexibility tends to result in high costs. Incentive schemes are inherently more flexible. They allow firms to choose how to reach targets and, through trade, how the overall control effort should be allocated.

A consensus is emerging that the degree of environmental regulation will increase in the medium and longer term, and that control will rely increasingly on pollution taxes and marketable permits. The following statement by two eminent American environmental economists, Cropper and Oates, illustrates this expectation:

“ ..effluent charges and marketable permit programs are few in number and often bear only a modest resemblance to the pure programs of economic incentives supported by economists. …….As we move into the 1990’s, the general political and policy setting is one that is genuinely receptive to market approaches to solving our social problems. Not only in the United States but in other countries as well, the prevailing atmosphere is a conservative one with a strong predisposition towards the use of market incentives wherever possible, for the attainment of our social objectives.”

Cropper and Oates 1992, pages 729 and 730.

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Markets often fail to deliver socially-efficient outcomes where a natural resource is characterised by conditions of open access. A resource is described as an open access resource when it is not possible to prevent anyone who wishes to use it from doing so, or where the cost of imposing such restrictions is prohibitively high. Examples of open access resources include

*marine fisheries
*wilderness areas
*natural forest areas, including tropical moist forests
*acquifers (i.e. surface and underground fresh water stocks)
*the earth’s atmosphere
*river systems

To illustrate why open access conditions often lead to inefficient outcomes, let us consider the case of a marine fishery. As we shall see, marine fisheries are prone to being over fished. In an extreme case, the stock of a particular species may be driven to a level at which it cannot recover, and the species becomes extinct.

There are two reasons why excessive harvesting is likely to occur in these circumstances. First, the actions of each fishing boat imposes external costs on all others. When one boat withdraws fish from the sea, the total stock is reduced, and so it becomes more difficult for others to catch fish. Each fishing vessel incurs private or internal costs, but also imposes external costs on others by increasing the amount of effort that is required to catch a given quantity of fish. The excessive harvesting arises because the owner of each vessel takes account of only private revenues and costs in deciding upon the amount of fishing to be undertaken. For a socially efficient outcome, all costs – private and external – should be included in this decision.

In conditions of open access, whenever private profits can be obtained, more vessels will tend to be attracted to fish in these waters. Where the number of boats is large, individualistic, uncooperative behaviour is likely to prevail. Even though each fisherman realises the effects of his actions on others, he is likely to proceed in a self-interested way, grabbing whatever he can on the assumption that everyone else is doing the same.

The second cause of inefficiency arises from the lack of incentives to “invest” in future stocks. When fish stocks are low, rational behaviour suggests that boat owners reduce their catch today to allow stocks to recover and grow. Investing in the future in this way offers the prospect of larger returns in the future for small costs today. But the open access regime implies that this action is very unlikely; any individual who invests in this way is unlikely to be able to appropriate the returns on his investment. The returns ultimately become available to the whole industry, not to the individual “investor”. Moreover, a free-rider problem exists here. Any one individual can benefit by others agreeing to reduce their catches, but by increasing his own catch (compare this with the cartel model we discussed earlier).

Market forces alone will not generate efficient collective outcomes because each fisherman will equate his private marginal costs and marginal benefits. The two kinds of externalities we have just described will drive a wedge between what is privately and what is collectively optimal. Clearly it will often be in the interests of fishermen collectively to agree to an optimum overall catch, together with quotas for individual fishing vessels, provided all parties to the agreement can be relied upon to maintain the agreement. This is most unlikely in open access conditions with large numbers of players in the industry; even if newcomers could somehow or other be prevented from gaining access, the transactions costs of creating and policing agreements will tend to be high, reducing the likelihood of efficient bargaining outcomes being attained.

It is common for governments, or supranational institutions such as the European Union, to intervene in and regulate the fishing industry. One common approach is to establish limited rights of access through territorial restrictions on fishing activity. However this can be at best only a partial solution to over-fishing, as it does not alter the open access to domestic fishermen. If fewer non British boats fish in British waters, for example, this may just encourage British vessel owners to step up their efforts. Regulation might also consist of attempts to impose limits on the size of the fishing fleet, and on the amount of fishing effort that is permitted. Some recent European regulatory policy has been directed at fishing effort, placing restrictions on seasons in which designated species may be harvested and the number of days on which vessels may put out to sea.

Other regulatory approaches tried include quotas on permissible catches (this is currently the major type of regulation in European waters) and controls relating to the type of equipment (boats, types of net, mesh sizes etc.) used in marine fishing. There seems to be little to suggest that any of the schemes we have considered here have met with much success in terms of reducing over-fishing. Moreover, the costs to fishermen of these types of control are immense. This is not surprising when one realises that they all share the characteristic of being command-and-control instruments, and do not provide patterns of incentives to vessel owners that address the root causes of overfishing.

One method that has been successful in New Zealand fisheries (The demise of the small fisher? A profile of exiters from the New Zealand fishery [An article from: Marine Policy]) – and could be more widely adopted in the future – is the use of transferable fishing quotas. These work in very similar ways to the transferable permit schemes we discussed earlier, and have similar advantages over more conventional forms of command-and-control.

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As we explained earlier, where goods are public rather than private, resources will tend to be inefficiently allocated. The inefficiencies we have in mind manifest themselves in two principal ways:
  • Under provision of public good

  • Under protection of public goods

Under provision follows from the non-excludability property and the attendant free-rider problem. It is difficult for a producer to extract a financial return for the provision of a public good, and so many public goods will either not be provided at all by free markets, or will be under-provided. Even if a firm could extract enough revenue to make market provision worthwhile, many people will tend to understate the extent of their willingness-to-pay and so market demand will be a systematically downwardly biased representation of the true social value of the good. Under protection of public goods tends to follow for similar reasons. Why would a profit-oriented owner of a public good (such as a tropical forest) bother to protect that asset for others to enjoy if no revenues can be extracted for that action?

A final problem concerns the efficient price of a public good. If the use of the good does not impose costs on others (which it will not do if it is a public good, because of the non-rivalry property) the socially efficient price should be zero! Recall that the efficient price is equal to marginal cost, which in this case is zero (once the good exists). So even if, somehow or other, a price could be extracted, any price other than zero would be socially inefficient!

The implication of these arguments seems to be that only the public sector is in a position to install or maintain pure public goods in socially-efficient ways. We have already noted applications of this idea to environmental problems. Another important application is to knowledge, and the processes which generate it: research, development and invention. Knowledge is close to being a pure public good. Think, for example, of the case of knowledge about a new drug formula. Once available, consumption of it is non-rivalrous. Also, as a matter of practice, it is nearly impossible to exclude others from using it. Will knowledge be generated in socially-efficient quantities in a pure market economy? Our analysis of public goods suggests the answer is probably no, and explains why the state plays such a large role, in most countries, in the generation of knowledge.

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The Costs of State Intervention

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Market failure occurs when resource allocation through market processes results in inefficient outcomes. We have suggested that state intervention can result in superior outcomes in these circumstances. But it is important to remember that intervention has costs as well as benefits. Market failure provides a prima facie case for intervention, but intervention is not of positive net benefit unless the social costs of intervention are lower than the social efficiency gains arising from intervention.

Intervention can be very costly, both in financial terms and in broader measures of social cost. The costs of regulating European agriculture, for example, are immense. What can be said in conclusion is that intervention is likely to be desirable in some circumstances, but we must always be careful to estimate the gains and costs of intervention.

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How should firms respond to regulations and the prospect of future regulations?

In developing business strategy, a firm should pay attention to the potential benefits of being “environmentally-friendly”. One such benefit might derive from reputation effects. An often remarked phenomenon in the last couple of decades has been the development of a number of markets in which consumers appear to be willing to pay price premia for goods or services that are perceived to satisfy certain environmental criteria. The magnitudes and growth rates of these markets are rather uncertain, but it seems safe to forecast that they will develop relatively quickly, particularly in the high income economies. Such reputation effects may be valuable assets to acquire, particularly in resource-based industries such as oil refining and timber production, where the links with environmental degradation are most evident. As consumer awareness of environmental linkages develops, so the range of products increases for which value can be gained from environmentally responsible behaviour. Detergent manufacturers now routinely promote brands using assertions about the low impacts of their products, and some large food retailing chains are now committed to selling food grown without the use of inorganic fertilisers and pesticides.

First mover advantages may also accrue to those firms who most quickly identify and respond to emerging market opportunities. In the short to medium term, environmental controls will have their greatest impact on firms that can offer waste management and emission reduction technologies. Legislation is moving in the direction of creating product life-cycle liability for environmental damages, and this will add to value creation opportunities in these sectors. In some industries, it has been common for firms whose goods are positioned towards the top of the product ranges to incorporate environmentally-friendly materials into their goods (such as BMW and Mercedes in the car industry), but the trend appears for this to spread down the range through time.

It should be clear from earlier discussions that so-called ecological tax schemes will be an important component of any future environmental protection programme. An important recent report from the DIW economic research institute in Berlin has investigated the effects of a tax on energy derived form fossil fuels, to rise at 7 percent annually over a ten year period. Tax proceeds would be used to reduce taxes elsewhere, in the German case by financing cuts in employers contributions to health, unemployment and pension funds. Whilst the package would be neutral in its overall fiscal impact, very substantial relative price changes would occur. For example, after ten years iron and steel prices would rise by nearly 20 per cent, whilst government service prices would fall by 3 per cent. Relative price changes of these magnitudes are bound to have large impacts upon the relative size and profit opportunities of different sectors of the economy.

Finally, substantial cost advantages are likely to accrue to firms which anticipate controls

rather than respond to controls ex post. These come about for two reasons. First, anticipation allows adjustments to be planned carefully and implemented gradually. Slow adjustment is invariably less costly than rapid, enforced adjustment. Secondly, in the learning processes that accompany accommodation to stricter environmental regulations, innovation will take place. Those in a position to build organisational strengths that are suitable for exploiting and sustaining these emerging techniques will be in the best positions to benefit form controls.

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