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October 6, 2011

Air Pollution and Alleged Market Failures

October 6, 2011
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The August issue of the prestigious American Economic Review carries an article estimating the social costs of air pollution from various industries. (The gated link to the published article is here, while a draft of the article is available here for free.) Naturally, pundits such as Paul Krugman jumped on the results as proof of how “scientific” is the case for more government intervention. Yet as we’ll see, the new paper by Muller et al. does no such thing. As usual, Krugman & Co. focus exclusively on theoretical market failures, and ignore the government failures staring us in the face on a daily basis.

What the Article Says—And Doesn’t Say

Here is the abstract of the paper:

This study presents a framework to include environmental externalities into a system of national accounts. The paper estimates the air pollution damages for each industry in the United States. An integrated-assessment model quantifies the marginal damages of air pollution emissions for the US which are multiplied times the quantity of emissions by industry to compute gross damages. Solid waste combustion, sewage treatment, stone quarrying, marinas, and oil and coal-fired power plants have air pollution damages larger than their value added. The largest industrial contributor to external costs is coal-fired electric generation, whose damages range from 0.8 to 5.6 times value added.

In the first place, it’s important to clarify what the paper is not saying. A good example of this misinterpretation is a Grist piece entitled, “Coal is the enemy of the human race, mainstream economics edition,” in which the author writes:

Once you strip away the econ jargon, the paper finds that electricity from coal imposes more damages on the U.S. economy than the electricity is worth. That’s right: Coal-fired power is a net value-subtracting industry. A parasite, you might say. A gigantic, blood-sucking parasite that’s enriching a few executives and shareholders at the public’s expense. [Bold and italics in original.]

Actually guys, sorry, that’s not what the paper says. If you had read it all the way through—maybe you got stuck on the “econ jargon” and stopped—you would have seen (on page 21 of the earlier draft available here) that the authors caution:

[W]e note that the finding of a negative adjusted value added does not imply that an industry should be shut down. Rather, it indicates that a one-unit increase in output of that industry has additional costs that are higher than the revenues. This cannot be extrapolated to infra-marginal adjustments.

This follows from the way the authors conducted their analysis. Assuming their numbers are right and that they included all relevant considerations in their model, the authors have found that reducing coal-fired electrical generation a little bit would be economically justified, because the gains in environmental value would offset the losses in electrical output. But if you keep repeating the process—as you make the air cleaner and cleaner, while making electricity more and more expensive—eventually you get to a point where it’s not economically justified to continue. In other words, even on their own terms, the authors are arguing merely that there is too much output from coal-fired power plants—not that these plants are a “parasite” on society.

If our friends at Grist think we’re lying to them, we can look at some other industries in the paper. For example, the authors also find that sewage treatment cause almost three times as much “gross environmental damage” as value-added to the economy. Somehow, I don’t expect the people at Grist to announce, “Sewage treatment an enemy of mankind!! We must stop treating sewage!”

While we’re at it, we should also quote some of the authors’ other reservations:

We note several qualifications about the results. First, our estimates are accounting measures and not measures of economic welfare. The economy has many pre-existing distortions other than those from air pollution – such as taxes, market distortions, and other externalities – and existing accounts do not attempt to incorporate those.…Fifth, we note that the uncertainties are particularly large for three elements: the treatment of the value of life or life- years, the value of CO2 emissions, and the dose-impact effect of small particulates. Sensitivity analyses using alternative values can change the magnitude of the results significantly. [Bold added.]

 As an exercise in humility, it’s important to step back and look at what our intrepid three authors are attempting: They are looking at an entire economy, composed of hundreds of millions of people, and estimating the gross effects of air pollution for various activities, and contrasting them with the value added to the economy in each of those activities. For those familiar with Friedrich Hayek’s Nobel lecture entitled, “The Pretence of Knowledge,” this will appear to be a bold undertaking indeed.

Paul Krugman Jumping to Conclusions

If the economic amateurs at Grist are bad, the Nobel laureate Paul Krugman is hardly better. Here was his reaction to the new paper:

What MMN do is estimate the cost imposed on society by air pollution, and allocate it across industries…

[T]hey find that the costs of air pollution are big, and heavily concentrated in a few industries. In fact, there are a number of industries that inflict more damage in the form of air pollution than the value-added by these industries at market prices.

It’s important to be clear about what this means. It does not necessarily say that we should end the use of coal-generated electricity. What it says, instead, is that consumers are paying much too low a price for coal-generated electricity, because the price they pay does not take account of the very large external costs associated with generation. If consumers did have to pay the full cost, they would use much less electricity from coal — maybe none, but that would depend on the alternatives.

At one level, this is all textbook economics. Externalities like pollution are one of the classic forms of market failure, and Econ 101 says that this failure should be remedied through pollution taxes or tradable emissions permits that get the price right. What Muller et al are doing is putting numbers to this basic proposition — and the numbers turn out to be big. So if you really believed in the logic of free markets, you’d be all in favor of pollution taxes, right.

Hahahahaha. Today’s American right doesn’t believe in externalities, or correcting market failures; it believes that there are no market failures, that capitalism unregulated is always right. Faced with evidence that market prices are in fact wrong, they simply attack the science.

What this tells us is that we are not actually having a debate about economics. Our free-market advocates aren’t actually operating from a model of how the economy works; they’re operating from some combination of knee-jerk defense of the haves against the rest and mystical faith that self-interest always leads to the common good.

As University of Rochester economist Steve Landsburg pointed out, Krugman is conveniently leaving out the fact that once we leave Econ 101, there is a whole body of literature inspired by Ronald Coase showing that pollution taxes or tradable permits might not be the best way to solve problems of “negative externalities.” Landsburg also notes that Krugman has a knee-jerk defense of government intervention; we’re not having a debate here over alternative social institutions for tricky problems like air pollution.

Government Failure and Market Solutions

Let me close by giving two simple examples of how the regulatory government approach might lead to an inefficient outcome, compared to the market. Suppose there is a factory emitting particulate matter that causes serious impacts on human health within a fifty-mile radius. However, the products of the factory are also very valuable. Initially, the factory is located next to a large city, where millions of people are subjected to the pollutants.

Under the Krugman Econ 101 approach, environmental economists engage in (necessarily) crude calculations and estimate that the factory imposes (say) $10 in damage to human health for every unit of its output. The government therefore imposes a direct tax on the factory’s output at $10 per unit. Facing the new tax, the factory slashes production by (say) several thousand units. Consumers are worse off because of the lower physical output, but—argues Krugman and other environmental economists—the residents of the nearby city are more than compensated by improved air quality.

However, as Ronald Coase’s analysis leads us to investigate, it’s possible that there is an even better outcome. What if the factory had simply moved away from the city, to a region with low population density? Then it could continue to crank out the physical production as before, but now its localized air pollution wouldn’t affect very many people. We would thus achieve perhaps a greater reduction in environmental damages, without suffering from a loss of the physical production.

Even though pollution taxes and tradable emission permits are more efficient than direct command-and-control approaches (which would have the government mandating particular emission targets or perhaps technologies to individual firms), the Coasian framework shows that it’s possible that the euphemistically labeled “market-based” regulation would still lead to inefficiencies. The problem is that when environmental economists calculate the “social cost” from an additional unit of production, they are assuming that the economy is configured in its current state. They might miss solutions such as a relocation of a factory, which would cause the “marginal social cost” from localized pollution to drop drastically.

“Fair enough,” the fan of pollution taxes might say, “but how would a free market effect such an outcome? Would the millions of people in the city have to make side payments to the factory owner to relocate? Surely those transaction costs are too high.”

This typical objection once again shows a failure to seriously give markets a chance. For one thing, large insurance companies would bear much of the costs of health problems. If there really were large amounts of “money on the table” from reducing exposure to air pollutants, then the insurers could come together and make offers to large companies responsible for pollution.

Another major consideration is that people are willing to pay more to live in areas with fresh air, as opposed to areas with high levels of smog. Financiers could construct arrangements where investors benefit from rising property values in a large area because of reduced air pollutants, and the initial emitters are compensated out of the gains.


The point with my above musings isn’t to offer a definitive solution to the difficult problems of air pollution. Rather, I am showing that it’s not enough for Krugman and the writers at Grist to identify problems with the existing set of property rights, and then conclude that taxes or emission permits are the “logical” response.

Instead, Krugman et al. would need to show the outcomes of both political and market reactions to these alleged externalities, and then explain why the former would be more efficient. To take one issue: Krugman links with derision to Rick Perry’s thoughts on the EPA. Krugman seems to think that Perry’s comments somehow bolster the case for government regulation.

Yet on the contrary, Krugman is showing that in the real world, we will never achieve “scientific” regulation of externalities through the political process. Krugman writes almost daily on the allegedly unscientific and corrupt Republican Party. Does Krugman think Democrats will be in the White House for the rest of time?

Rather than focusing exclusively on alleged market failure, while completely ignoring real-world government failure, economists should be open-minded in their attempts to include environmental issues in standard economic analysis.

Rather than giving government yet another source of tax revenue and regulatory control, a more efficient reform could be better definitions of property rights and the removal of legal hurdles to the types of transactions that might mitigate pollution damages through contractual agreements.

Despite their public show, I don’t think Krugman & Friends actually take these numbers seriously, or at least they recognize that independent parties wouldn’t be convinced. For example, Table 2 in the study indicates that coal-fired power plants cause $34 billion in gross environmental damages, which is supposedly 1.41 times their value-added. Taking those numbers at face value (i.e. disregarding the issues of “inframarginal units” discussed above), that works out to about $10 billion in “money on the table.” Suppose major health insurers stuck a deal with utility companies, paying them to reduce their emissions, and that such a deal captured just 1 percent of this economic surplus: that’s still $100 million. Since the political route doesn’t look promising right now, are the people at Grist and Paul Krugman shopping the study to health insurers? If Krugman et al. really believe these numbers, there are potentially hundreds of millions of dollars waiting to be plucked. So right now Krugman and friends are sending emails and making calls, right? To quote a Nobel laureate, “Hahahahaha.”


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