By Charles Kolstad
Markets sometimes fail to allocate resources efficiently. Such failure is particularly prevalent in the environmental arena where markets tend to underprovide environmental goods such as parks and open space and overprovide environmental bads such as air pollution.
A common solution to market failure is government provision or regulation. But as free market environmentalists have argued, this path includes failures of its own—government failures. The literature on free market environmentalism (FME) has consistently documented the problems associated with government providing public goods. The argument, well buttressed by evidence, suggests that in many cases markets are more efficient than the government at protecting the environment. And where market failure is persistent, modifying institutions to define property rights can often solve the failure.
While FME has much to offer for problems pertaining to natural resource allocation, the case for FME is weaker when dealing with environmental goods, such as providing clean air. The basic problem lies in the nature of the market failure.
One type of market failure is the inability to exclude individuals from using the good. Economists call this nonexcludability. Excludability is necessary for a market to operate so that individuals can exchange money for access to the good. Free market environmentalism focuses on designing property rights—institutions that can overcome the nonexcludability. With well-defined property rights, I can restrict your access to a good that I may own. Natural resource problems, which are plagued by nonexcludability only (open-access problems) are perfect candidates for FME solutions.
The other type of market failure is more subtle and has to do with the nature of consumption. If my consumption of a good precludes your consumption of a good, economists call the good rival (e.g., a hamburger). If my consumption of a good does not diminish what is available to you, we call the good nonrival (e.g., open space or pollution). Rivalry is necessary for a market to function efficiently. Environmental problems that involve nonrivalry are not “fixed” by well-defined property rights. Here, markets may function but they will not function efficiently. In this case, FME may improve an allocation but FME cannot “fix” the market failure.
FME AND NATURAL RESOURCES
To further explore the promise and problems of FME, consider the following examples. Forests in the United States provide three primary services: timber, recreation, and habitat. Terry Anderson and Donald Leal make a good case in their classic book, Free Market Environmentalism, that the politically-driven Forest Service does a mediocre job of managing forests. They point out that state forests are often better managed for timber and recreation and show that private forests generate revenue from recreation as well as from timber and thus have an incentive to manage the forests to provide both. They further argue that some habitat protection can be converted into habitat for hunting (for which hunters will pay handsomely). Finally, for environmental habitat, the authors argue that non-government organizations, such as the Nature Conservancy, raise funds to invest in habitat protection on private lands.
This argument is sensible for timber production. Timber is basically a private good and the case that private actors provide more efficient management is convincing. The argument is less persuasive for recreation and habitat. Some types of recreation, such as campgrounds, are rival and can be provided privately. But other aspects of recreation, such as open spaces and hiking trails, are generally nonrival. In these cases markets tend to set prices too high, and supply will be smaller than efficient. The FME argument that private markets will provide habitat relies either on recreation being correlated with habitat such as hunting or the existence of environmental organizations providing habitat.
Water supply in the arid West is another important example. Water is valued for consumptive uses such as agriculture and for nonconsumptive uses such as habitat. And water supply is subject to significant fluctuations, leading to drought and flooding. The key issues are managing consumption, so that uses with high social value are adequately served, and augmenting storage facilities to smooth out the natural fluctuations in water supply.
When the West was settled, the common law method of allocating water rights prevailed. The prior appropriation doctrine emerged as a response to scarcity. Under this standard, water rights are decoupled from land and thus can be bought and sold. Here FME principles are working to help solve the consumptive use problem.
Nonconsumptive uses of water, however, may not fit as well into the FME framework. There is a growing recognition that maintaining minimum river flow or unobstructed passage through a river has environmental benefits—particularly to fish. These fish may be part of a commercial or recreational fishery, in which case markets may reflect demand, or the fish may be part of an ecosystem with societal values that are outside of markets. In this latter case, the commodity (a noncommercial species) is nonexcludable and nonrival and thus not as amenable to market allocation and FME solutions.
Managing ocean fisheries presents another challenge for FME as fisheries are not fenced and are thus nonexcludable. Yet the emergence of creative property rights regimes to overcome the open-access problem is addressing this issue. Catch-share systems have evolved to allocate an exclusive share of the total allowable catch to individual fishers or cooperatives. Such property-rights regimes work when fisheries fall within a country’s economic zone. In some cases, countries such as Canada and the United States can cooperate to manage fisheries that span across more than one country. But property-rights regimes that cover fish that migrate over long distances, such as tuna, will be more difficult to develop.
FME AND POLLUTION
The previous examples of FME solving an efficiency problem concern natural resources. Pollution and waste production and disposal are another area of environmental concern. Markets work fine for municipal solid waste, which is rival and excludable, as long as there are laws against littering. In fact, in many parts of the United States, municipal waste disposal is private. The only point at which it breaks down is the ultimate disposal—assuring that wastes do not leach into the ground water.
The FME solution to air pollution is more problematic. An idea typically offered includes a technological innovation such as seeding emission streams with tracers to determine how much of the ambient pollution is due to specific sources. Another solution is to rely on common law or nuisance law—if party A is causing injury to party B through pollution discharge, then party A may seek remedy in court.
These ideas for managing air pollution are unsatisfactory. Smoke and similar types of air pollution are nonrival bads. Even if property rights could be defined to make this bad excludable, which is beyond current technology, the fact that the bad is nonrival means that market solutions will not be efficient. If one could identify the source of all of the pollution in Los Angeles, the transaction costs associated with victims seeking remedy in court would be enormous and would inevitably lead to inefficient provision of pollution—the advantage is with the polluter. Even if the nonexcludability component can be overcome through technology and innovative property rights arrangements, the nonrival nature of most pollution problems means that government and regulation must be central players in managing these resources.
WHAT CAN BE DONE
The basic problem is that FME relies on properly defined markets to take care of both the supply and demand for environmental and natural resource goods. This works well in many cases. But the demand side cannot be fully decentralized in the case of nonrival goods and bads. What can be done, and perhaps this should be embraced as part of FME, is that the government can set up markets to implement societal goals such as tradeable permit markets. This does not completely solve the problem of government failure since the societal goal being implemented may not be optimal. One example is the use of Renewable Energy Credits (RECs). Electric utilities are charged with achieving a certain fraction of their generation from renewable sources. Furthermore, the renewable nature of generation can be unpackaged from the electricity and bought and sold in a market. These are the RECs. The market will efficiently implement the societal goal. The societal goal, however, is questionable. If the goal is to control carbon, why not do that directly rather than through an indirect means?
A pseudo-FME approach to solving the nonrivalry problem is to use artificial markets to allocate the environmental good—for instance, an emissions fee. We have not had enough experience with such decentralized economic incentives, but there are indications that there may be political problems in implementing an artificial market for environmental goods. That evidence comes from experience with attempts to implement congestion charging around the world, most recently the failed attempt by Mayor Michael Bloomberg to implement such a system in New York.
Although evidence is mixed, the public appears to be reluctant to embrace the use of prices for incentive purposes only. To an economist, improving incentives is the primary reason for implementing prices on pollution. But the public appears to be much more comfortable and supportive of prices being used to raise revenue to pay for something worthwhile. In a 2008 review of opinions on road pricing around the world, Johanna Zmud and Carlos Arce concluded that the disposition of the revenue raised is key in increasing support for road pricing and tolls. However, as scholar Jonas Eliasson explained, this is not unequivocally true, as support for congestion pricing in Stockholm increased with experience.
The point is that using artificially induced prices for pollution primarily serves an incentive purpose. It is not clear that there is political support among the population for such a use of prices, as opposed to the conventional revenue-raising use of governmentinstituted prices. The jury is still out on this issue.
Can free market environmentalism be applied to all environmental problems?
Free market environmentalism works well for problems pertaining to natural resource allocation, where well-defined property rights solve the problem of excludability. It is less efficient at dealing with environmental goods, such as the provision of clean air, which is nonrival. Proponents of free market environmentalism rely on markets to take care of both the supply and demand for environmental and natural resource goods. While this may work for natural resources, the demand side cannot be fully decentralized in the case of nonrival goods and bads. What can be done? Government can set up markets to implement societal goals such as tradeable permit markets.
Charles D. Kolstad is a Professor in the Bren School of Environmental Science & Management and in the Department of Economics at the University of California, Santa Barbara. He is also Co-Director of the newly established University of California Center for Energy & Environmental Economics, a University Fellow at Resources for the Future, and a research associate at the National Bureau of Economic Research. He is a former president of the Association of Environmental and Resource Economists and has authored more than 100 publications, including the undergraduate textbook, Environmental Economics.