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Economic Report of the President – 2004

Chapter 9: Protecting the Environment

Economic growth and environmental improvements go hand-in-hand. Economic growth can lead to increased demand for environmental improvements and can provide the resources that make it possible to address environmental problems. Some policies aimed at promoting environmental improvements can entail substantial economic costs. Misguided policies might actually achieve less environmental progress than alternative policies for the same economic cost. It is therefore important to weigh the direct benefits of environmental regulations against their economic costs.

While the free-market system typically promotes efficiency and thus enhances economic growth, the absence of property rights for environmental “goods” such as clean air and water can lead to negative externalities that reduce societal well-being. This can be addressed by establishing and enforcing property rights that will lead the affected parties to negotiate mutually-beneficial outcomes in a market setting. If such negotiations are expensive, however, the government can design regulations that consider both the benefits of reducing the environmental externality as well as the costs the regulations impose on society. Regulations should be designed to achieve environmental goals at the lowest cost possible, thus helping to achieve environmental protection and continued economic growth.

The key points in this chapter are:

• Establishing and enforcing property rights for the environment can address environmentally-related market failures. Any needed regulations should consider both the benefits and the costs.

• Environmental risks should be evaluated using sound scientific methods to avoid possible distortions of regulatory priorities.

• Market-based regulations, such as the cap-and-trade programs promoted by the Administration to reduce common air pollutants, can achieve environmental goals at lower cost than inflexible command-and-control regulations.

The Free Market and the Environment

In a free-market system, only trades that benefit both parties will take place. Market prices coordinate the activities of buyers and sellers and convey information about the strength of consumer demand for a good, as well as how costly it is to supply. In the context of the environment, a market failure may occur if a voluntary transaction between parties imposes involuntary costs on a third party. These involuntary third-party costs are known as negative externalities (or spillovers), and their existence in a free market can lead to inefficient outcomes; that is, outcomes that fail to maximize the net benefits to society. For example, a plant might produce and sell a good to a consumer to both their advantage, but the production process may result in emissions of air pollutants that negatively affect others not involved in the transaction. The root of the market failure is that there are no clear property rights for the surrounding air. The interests of the third party—the people affected by the plant’s emissions—are not represented in the market transaction.

If those affected by the plant’s emissions had a right to demand compensation for the costs imposed on them by the pollution, then the firm would take these costs into account when making its production decisions. The plant would produce only up to the point where the benefit of another unit of production equals the additional cost of producing the good plus the cost to the people negatively affected by the pollution. Any additional emissions due to producing more goods would require compensation that is greater than the monetary gain the plant gets from selling the additional goods. Likewise, if the property right belonged to the plant, the people negatively affected by the emissions could compensate the plant for reduced emissions. Either way, all three parties (consumers, the firm, and those affected by the emissions) would transact voluntarily to everyone’s benefit, resulting in an efficient outcome. If the government were to assign and enforce the property right, and if it were costless for parties to collectively agree on compensation, then an efficient use of resources would result from private bargaining, regardless of which party was assigned the property right. This insight is known as the Coase theorem.

The complete chapter as well as the the complete Economic Report of the President are both available as PDFs.

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