Question

Explain the four conditions that must hold for the existence of a well-defined property rights system, and address why all four matter. Why do economists promote the idea of creating markets for environmental protection? Explain how Pigovian taxes work to control pollution? How do tradable pollution permits work in theory?

Answer 1

a. Property rights are theoretical socially-enforced constructs in economics for determining how a resource or economic good is used and owned. Resources can be owned by (and hence be the property of) individuals, associations or governments.Property rights can be viewed as an attribute of an economic good. The four conditions or components that must hold for a well defined property rights are:

1. the right to use the good
2. the right to earn income from the good
3. the right to transfer the good to others, alter it, abandon it, or destroy it (the right to ownership cessation)
4. the right to enforce property rights

In economics, property is usually considered to be ownership (rights to the proceeds generated by the property) and control over a resource or good. Many economists effectively argue that property rights need to be fixed and need to portray the relationships among other parties in order to be more effective.

b. Economists argue that environmental assets, because they are free or underpriced, tend to be overused or abused, thereby resulting in environmental damage. Economic incentives seek to correct this situation by setting a price for environmental damage or creating ownership rights to environmental goods.

Some environmental resources–such as timber, fish and minerals–are bought and sold in the market. But their price usually does not reflect the true cost of obtaining them because it does not include the cost of the environmental damage that may ensue from their extraction and processing. Other environmental resources such as the atmosphere and waterways are public or social goods that are not individually owned, or bought and sold, and do not have a market price. Economists argue that there is a strong tendency for people to overexploit and degrade these common property resources.

When individuals or firms make decisions about production, consumption and investment, they generally do not consider the environmental or social consequences because they seldom have to pay the cost of those consequences. For example, a company that discharges its effluent into a river affects fishers and other users of the water downstream. Yet the costs suffered by downstream users are not charged to the company nor built into the price of the company's products. The market does not take account of these environmental costs and they do not appear in the company’s account books. These ‘spillover effects’ of doing business have been called ‘externalities’ by economists, indicating that they are external to normal market transactions.

The Commonwealth Government identifies two main types of economic instruments for providing an incentive to use resources sustainably:

• Price-based measures use charges and subsidies to internalise environmental costs and benefits.
• Rights-based measures ‘create rights to use environmental resources, or to pollute the environment, up to a pre-determined limit, and allowing these rights to be traded’.

c. Pigouvian Tax is a tax on economic activities that generate negative externalities, which create costs that are borne by unrelated third parties. The costs arising from negative externalities are not reflected in the final cost of a product or service. Therefore, the market becomes inefficient.

The main purpose of Pigouvian taxes is to oppose market inefficiencies by increasing the marginal private cost by the amount generated by the negative externality. In such a case, the final cost (original cost plus tax) will reflect the full social cost of the economic activity. Subsequently, the negative externality will be internalized.

Pigouvian taxes can be imposed to challenge the following activities:

• Environmental pollution
• Harmful substances (tobacco and alcohol)
• Congestion

In the ideal world, the Pigouvian tax will be imposed at an amount equal to the costs associated with the negative externality. When Pigouvian taxes are imposed, the supply of the economic activity producing the negative externality will decrease.

Therefore, the quantity demanded will decrease while the price will increase. Therefore, the market equilibrium will become socially efficient because the social marginal cost will become equal to the private marginal cost.

d. Ensuring good water quality is an essential step towards water security. Consequently, pollution control is a big part of water resource management. Tradable pollution permits are so-called cap and trade schemes. They give companies a legal right to pollute a certain amount per fixed time span. Firms that pollute less can then sell their leftover pollution permits to firms that pollute more. The point of this is that polluting firms and public agencies differ in their ability to abate their pollution – some can do it easily and cheaply, for others it would be more difficult and costly. Consequently, tradable pollution permits can be a cost effective way to achieve a reduction in overall pollution.

The freedom to trade pollution “entitlements” gives an incentive for polluters to consider abatement (since they can sell their surplus quotas) while others face the cost of having to purchase permits. For society, the existence of tradeable permits enables pollution abatement to be achieved in the least costly manner. Over time, pollution standards can be tightened, increasing the value of the permits and the pressure on market participants. Credits are traded within defined trading areas.

Trading in pollution permits arises in the following situations:

• Permits to discharge into specific water bodies issued to local firms and wastewater treatment plants (e.g. Fox River, USA);
• Salinity Credits (e.g. for coal mining and power companies discharging into the Hunter River in Australia);
• Nutrient trading (e.g. in parts of the USA, Canada, Netherlands, and Australia). Transactions listed under some schemes include “bubble licensing” (in which several wastewater treatment plants are considered together in applying nitrogen and phosphorous load discharge limits) and “diffuse source offsets” (in which a water authority can purchase offset credits from external sources using much cheaper ways of reducing overall nutrient pollution).