Efficiency Standard

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Figure 1 Efficient level of pollution control.
Figure 1 Efficient level of pollution control.
Figure 2 Costs of Pollution Abatement.
Figure 2 Costs of Pollution Abatement.

Figure 3 Effect of pollution on equilibrium.
Figure 3 Effect of pollution on equilibrium.

As we saw in the previous chapter, an efficient market is a market in which demand and supply are in balance. The market demand curve represents the amount people are willing to pay for one additional unit of output at each price, i.e. what people pay for the pleasure of having one extra unit of the good (marginal benefit). Similarly, the market supply curve represents cost incurred by the firm to produce each additional unit of good (marginal cost). If the price rises above this equilibrium point, the quantity demanded for the good drops, but suppliers would be willing to increase their production and new suppliers are willing to enter the market. The imbalance between the supply and demand pushes the price down and equilibrium is achieved again. The opposite will be true when price drops, but the final result will be the same. Applying this concept to pollution control, we note that the marginal costs of reduction will be increasingly higher per unit reduction in pollution (easier cleanups are done first) and marginal benefits of reduction are lessened as air gets cleaner and cleaner. For example, it is costlier to reduce nitric oxide concentrations from 100 to 99 ppm than it would be to reduce it from 1000 to 999 ppm. At the same time, the marginal benefit the society receives (in terms of lower health risks, for instance) with reduction in nitric oxide’s concentration drops (Figure 1). Figure 2 shows the estimated marginal costs of nitric oxide abatement (in Euros/ton) for OECD and the former Soviet Union in 2010. As the data shows the graph is highly nonlinear. With the current technology, the cost of emission reduction is fairly small for removal of up to 50% of the pollutants, rises rapidly up to 80% and becomes prohibitively expensive if the last 20% of the emission is to be cleaned up (1). That is, as the level of pollution in the atmosphere decreases, we reach a point where further cleanup effort requires costs too excessive for the society to bear.


Coase Theorem

There is no question that a clean environment will benefit public health and reduce medical costs. It seems to be a no-brainer that whoever pollutes the environment has the moral responsibility to pay for cleaning the environment. From an economical standpoint, however, society as a whole does not care whether the polluter or the victim pays for the cleanup. As long as victims and polluters reach a mutual agreement, in the absence of any regulation and in a truly competitive market, it makes no difference whether the victim or the polluter pays for the cleanup. In other words, it does not require victims to necessarily be compensated. That is the equilibrium point is where bargaining between the two parties leads to efficient levels of pollution.

Question: To protect the public, environmentalists propose strict environmental regulations that restrict the dumping of pollutants into the atmosphere. How does the efficiency standard address the concern for public safety?

Answer: Victims always have the option of suing the polluters to recover the cost of cleanup and other damages. By doing so, the cost of production increases, which forces polluters to invest in cleaner technologies or acquire effective pollution control equipments.

Consider, for example, the transportation of crude oil from Alaska to refineries in California (2). The suppliers ship Q* barrels of oil at a cost of P* that includes the price of the good and ordinary transportation expenses such as wages for the crew, the cost of the ship, port taxes, etc. This is shown along the supply line S (Figure 3). In addition to these expenses there are costs associated with the spillage of oil along the route used by the oil tankers. If these costs are internalized, the supply curve shifts from S to S1 and the quantity shipped is reduced from Q* to Q1.

Let’s consider two situations: a) the tanker operators have the right to spill without having to pay any penalties for environmental damage; and b) the fishing industries have the right to demand that tanker operators reduce the shipment or even stop it altogether.

If tanker operators own the rights to shipping, then they would continue to ship Q* barrels instead of the optimum value Q1. In this case fishers have to convince the operators to reduce their shipment from Q* to Q1. If they succeed, damages would decline by the area shown as trapezoid abed. This requires fishermen to make two side payments, one to the tanker operators for forfeiting a profit equal to the triangular area bdg and another to the operators’ customers, the refineries, in an amount equal to the triangular area gde for compensating their losses from lower sales. The total payment to operators and refineries is therefore gdebdgbde+=. Fishers have an incentive to pay for these costs because they are still left with a net gain of bdeabedabd−=. Overall, fishers are better off reducing environmental damage as a result of shipments being reduced from Q* to Q1, while there is no monetary impact on operators or refineries. We can therefore conclude that a side payment will be paid by fishers to operators and refineries, and only Q1 units of oil will be transported.

If the fishers own the rights to clean water, then they can opt to insist on reducing the shipment or stop it altogether. In this case, the operators and refineries may choose to offer side payments to fishers for obtaining the rights. But how much are they willing to offer? If they manage to obtain the rights of shipping Q1 barrels of oil from fishers, they are to benefit with a profit as high as hbef, the difference between their revenues and costs. At the same time, fishers are willing to accept as low as cbef, an amount equal to the environmental damage to them. For any amount above Q1, fishers demand an amount exceeding the additional revenues by the tanker operators which therefore cannot be collected. We can conclude that a side payment will be paid by operators and refineries to fishers, and again, only Q1 units of oil will be transported.

This example shows that, irrespective of whether the polluter or victim pays for the pollution, the result is exactly the same. This is named Coase Theorem after Ronald Coase, the 1991 Nobel Laureate in Economics.

Question: What do advocates of the efficiency standard say about second-hand smoking?

Answer: Smokers have as much right to enjoy smoking as non-smokers have to enjoy clean air. We cannot discriminate against anybody on the basis of whose rights are more valuable.

Economic Efficiency

The term “efficiency” means different things to different people. Engineers talk about efficiency as the ratio of the desired output from a device to necessary input. An energy-efficient refrigerator uses less electricity for the same amount of cooling than a less efficient refrigerator uses (See Thermal Energy). An efficient worker performs more work in a shorter time, and an efficient programmer writes the same program with fewer instructions.

Social scientists refer to efficiency as the cost that society as a whole will pay compared to the cost if certain actions were or were not undertaken. For example, the social cost if there are no energy conservation policies could include a rise in pollution, degrading health, social unrest, hunger, job loss, and a decline in the economy overall.

Economists refer to efficiency in terms of the maximum profit that can be gained from a given transaction. The most widely accepted definition of economic efficiency is Pareto efficiency. A market is most efficient when it makes the public as a whole “better off.” As long as the market has not reached its most efficient point, the economic pie enlarges and, in principal, everyone can benefit by getting a bigger slice.

Question: When does the market for a car sales reach its peak economic efficiency?

Answer: As long as there are buyers who are willing to pay for the cost of owning a car and there are sellers who are willing to satisfy customers’ demands, the market has room for additional cars. That is, the market is Pareto efficient when demand balances supply.

Question: Is a “zero pollution” solution compatible with the concept of economical efficiency?

Answer: The zero pollution option will not make the outcome economically efficient. Although the public is willing to pay for certain amount of cleanup cost, at a certain point the increase in the marginal cost of cleanup does not justify the marginal benefits and brings enough economic hardship to a large number of people that the happiness of some would not make up for the unhappiness of the rest.


(1) Harmelen, T., et al., “An analysis of the costs and benefits of joint policies to mitigate climate change and regional air pollution in Europe.” Soil and Water Pollution, 5, pp. 349-365, 2002.

(2) This example is borrowed from Economics Today, by Roger LeRoy Miller and Daniel K. Benjamin, Addison Wesley Educational Publishers, Inc, 2001-2002.

(3) Toossi Reza, "Energy and the Environment:Sources, technologies, and impacts", Verve Publishers, 2005

Further Reading

Chapman, D., Environmental Economics: Theory, Application, and Policy,” Addison-Wiley, 2000.

Goodstein, E. S., Economics and the Environment, 4th Ed., John Wiley & Sons, 2002.

Siebert, H., Economics of the Environment: Theory and Policy, Springer Verlog, 2004.

Dauvergne, P., Handbook of Global Environmental Politics, Edward Elgar Publishing, 2005.

Journal of Environmental Economics and Management (JEEM), the journal of Association of Environmental and Resource Economics.

Ecological Economics – Direct Science Elsevier Publishing Company, the journal of the International Society for Ecological Economics (ISEE).

Environmental Economics and Policy Studies – Published by Springer-Verlog, New York is the official journal of the Society for Environmental Economics and Policy Studies.

External Links

US Agency for International Development (http://www.usaid.gov/)

National Center for Environmental Economics (http://yosemite.epa.gov/ee/epa/eed.nsf/pages/homepage).

United Nations Development Program (http://www.undp.org).

United Nations Environment Programme (http://www.unep.org).

Intergovernmental Panel on Climate Change (http://www.ipcc.ch).

World Resource Institute (http://www.wri.org)

Union of Concerned Scientists (http://www.ucsusa.org).