Notes 2- Based on Kolstad Ch-11

What is environmental regulation? Why is it needed? Why is it that command and control
dominate environmental regulations when most economists believe that economic incentives
to be a much better regulation? (2016)

Rationale for Regulation

Though economic theory suggests that markets are effective in efficiently allocating private goods,
markets tend to fail in efficiently allocating environmental goods because of their `public' nature.

In "Environmental Economics", Kolstad introduces us to the basics of pollution regulation,

where the government acts as the regulatory authority in dealing with externalities associated
with pollution.

The two basic theories of regulation set forth in this chapter are public interest theory and
interest group theory.

 The first, public interest theory, views the purpose of regulation as the promotion of the
public interest", and the authors suggest three general reasons why regulation might exist:
(1) imperfect competition, (2) imperfect information, and (3) externalities.
 And second, interest group theory, suggests that regulation exists to promote the narrow
interests of particular groups in society, such as individual industries.

Public interest theory can be viewed as a normative theory of regulation, while, interest group
theory can be viewed as a positive theory of regulation.

Political economy model of regulation

 One of the main goals of environmental regulation is to incentivize polluters to take a

socially desirable action, though the regulator may not know what is the socially desirable
level of pollution in a society.
 Apart from the `hard-science' which may inform regulators of optimal levels of pollution,
the government often faces pressures from consumers and producers to enact policy in
their own self-interest.

Because of this, the authors present a stylized mapping of the interactions between
government, Producers (i.e. polluters), and consumers (i.e citizens), as shown in
Figure 1 below.

Here, the government consists of three branches, the legislature, the judiciary, and the
regulators, each defined by their role in the regulatory process.

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 Next, the firm, consisting of the board of directors, stock and bond holders, managers, and
employees, are influenced to take certain actions based on the regulatory process described
above.

An
example of
this may be
to install
scrubbers
in smoke
stacks, or
to, more
generally,
innovate
and adapt
clean
production
processes.
As the
authors
note, the firm may not be a passive entity but may in fact influence legislation, through
lobbying or financial incentives."

Finally, consumers are the individuals who consume both the goods produced by the firm,
as well as the pollution emitted by the firm.

Thus, environmental regulation is aimed to serve the consumers, though regulation is an

indirect means to promote social welfare, as it directly effects producers, who in turn have
an effect on consumers.

Limits of Regulation

 Regulation may be an ineffective means to promoting social welfare as it may provide

perverse incentives to cheat or over-pollute.
 Also, the regulators may not act as a benevolent maximizer of social well- being if it is
influenced by other interests, particularly those of the firm (referenced above as interest
group theory).
 Here, the author makes a point to distinguish between exogenous and endogenous politics,
where the former (Line A in Figure 1 below) coincides with public interest theory, and the
former (Line B in Figure 1) with interest group theory.
 As noted, environmental regulation is often susceptible to interest group influence
because the costs of environmental regulation are often high, thus significantly
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 cutting the profits of the firms, incentivizing them to influence policy in favor of
sustained profits.

Two major types of environmental regulation: command and control & economic incentives.

1. Prescriptive Regulations (Command & Control Regulations):

 To specify the steps individual polluters must take to solve pollution problem.
 The regulator collects the necessary information to decide physical actions to control
pollution.
 The regulator then commands the polluter to take specific physical steps to control
pollution.
Definition: Prescriptive regulations (Command & Control Regulations) involve the
environmental regulator stipulating the action that an individual firm or polluting facility
should take with regard to pollution control or other environmental protection, though the
firm may have some limited flexibility in how it meets the regulatory requirements.
Two basic types of Prescriptive Regulations:
i) Technology Standards
ii) Performance Standards
Technology Standards: It specifies a particular type of technology or equipment to be used.
It is easy to monitor whether the equipment is installed or not.
Performance Standards: Stipulating the maximum emissions allowed per unit of economic
activity. It gives discretion to the polluter as to how the emissions to be controlled. It can help
improve the cost effectiveness.
 Combination of both standards are used sometime.
 Penalties and fines are also attached to non-compliance.
Prescriptive regulations and economic outcomes:
1. Restricted choice for the polluter in choosing means to achieve an environmental target.
2. Lack of mechanism to equalize marginal control cost among different polluters.
3. All the prescriptive regulations have centralization of some of the pollution control
decisions that could be made by the polluter. (Information problem)
Advantages of Prescriptive Regulations:
1. It gives more flexibility to complex environmental regulation processes.
2. More certainty to the ultimate level of pollution.
3. Simplifies monitoring of regulation

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Disadvantages of Prescriptive Regulations:
1. Because of huge cost of information this system of regulation can be very costly to
administer.
2. The regulator often needs to rely on the information provided by the polluter. So,
polluter can provide a distorted information.
3. Reduced incentives to find better ways to control pollution.
4. Difficulty in satisfying equi-marginal principle. For efficiency Marginal Control Cost
should be equal for all the polluters generating same pollution otherwise pollution will
remain high.
5. Polluters pay only for the pollution control and not for the residual damage from the
pollution that still emitted even after the control. This effectively subsidises the
polluters.

There are two key features which distinguish command and control from economic
incentives:

(1) restricted choice for the polluter and (2) a lack of mechanisms for equalizing marginal control
costs. Each of these together limit the choices by which a firm may achieve some emissions
reductions. For example, if a regulator commands emissions controls via a specific method, the
polluting firm has to forego cheaper alternatives which would achieve the same level of emissions
reductions.

2. Economic Incentives:

Economic incentives encourage polluters to do what is perceived in the public interest by

providing rewards (penalties) for doing good (bad), by aligning public and private incentives.

Kolstad specifies three basic types of economic incentives:

(1) fees,
(2) marketable permits, and
(3) liability.

 Fees force the polluter to pay per unit of pollution emitted (often referred to as a Pigovian
Fee). Because the polluter is penalized for doing a bad (i.e. polluting), they have the
incentive to change their behavior and it is in their interest to pollute less because of the
fee.
 Marketable permits are a form of regulation which gives polluters the ability to buy and
sell the right to pollute. As permits are traded back and forth between firms, their price (i.e.
value generated from trading) causes the polluting firm to see pollution as a costly activity,
and thus incentivizes them to pollute less. As the authors note, the less a firm pollutes, the
more it is able to sell these marketable permits, and thus the more it is able to generate in
profits, as long as they revenues from permit sales are greater than the costs of pollution
reduction.
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 Liability provides incentive to pollute less as it holds polluting firms responsible for
damages caused by the pollution. As the authors note, this means that when you undertake
a risky activity, you will take all potential damage from your activity into account when
deciding how carefully to perform your activity.

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Advantages of Economic incentive: Economic incentives have a number of advantages over
command-and-control forms of regulation.

 First, the information requirements are less significant because it places the decision
process for pollution control in the hands of the polluters, arguably the individuals who are
most familiar with pollution control options.
 Because of this, economic incentives work to reduce the costs of pollution control through
firm innovation.
 And another advantage of economic incentives over command and control is that the equi-
marginal principle will automatically hold for most types of incentives. That is, firms will
set their marginal cost of pollution control equal to the level of the fee or to the price of
the marketable permit.

Disadvantages of economic incentives:

 A notable problem with economic incentives is their inability to accommodate potentially

complex pollution control problems, such as urban air quality, which varies greatly over
space and time.
 Further, economic incentives are also politically decisive as adjustments to fees or permits
may be very impractical.
 Further, economic incentives also often involve transfers from firms to the regulator (i.e.
from pollution fees), and thus can be very difficult to enact politically, especially under the
pretense of interest group theory.
 Commoditization of environmental pollution, a serious ethical concern.

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Complications with enacting environmental regulation

There are many complications with enacting environmental regulation, three of which include

1) space and time considerations,

2) efficiency versus cost effectiveness, and
3) ambient- versus emission differentiated regulations.
 First, the ambient concentrations of environmental pollutants are the substances that cause
harm, and emissions themselves often have no direct impact. Thus, it is ambient
concentrations that should be of concern when discussing environmental regulations.
Space and time have an impact on ambient pollution concentrations, as pollution sources
in major metropolitan areas will have more of an impact on those in distant suburbs.
Further, time affects ambient pollution concentrations and designing effective policy to
take this into account is difficult.

 Second, in an ideal world, regulations would target environmental damage and ambient
concentrations. But often, regulations target levels of emissions. Efficiency in
environmental regulations requires emissions that equate the costs of emissions controls
with the damage from ambient pollution, but this is often very difficult because of
insufficient information about ambient pollution concentrations. In this case, the goal of
regulation is to control individual polluters in such a way to achieve the emission target in
the best way possible. This often involves trading off efficiency for cost effectiveness, in
which a set of environmental regulations is considered cost effective if it reaches emissions
targets in the least costly way. Efficiency is often not possible with complex environmental
issues, but cost effectiveness is an attainable goal.

 Finally, there is a distinction between ambient-differentiated and emission-differentiated

regulations. Ambient-differentiated pollution controls will treat a unit of pollution
differently between polluters, as they each affect ambient pollution concentrations in
different ways. Emissions differentiated regulations will treat a unit of pollution between
polluters as the same, and thus will be controlled in the same way. It is often more difficult
to enact ambient-differentiated pollution controls as there is more uncertainty about
individual firm’s contributions to ambient-pollution levels. Thus, emission-differentiated
regulations can be seen as the cost-effective solution when pollution is complex.