Andri G. Wibisana
2. THE POLLUTER-PAYS PRINCIPLE
2.1. The Origin of the Principle
One area of microeconomics, referred to as welfare economics, has paid a great deal of attention in exploring how the market can coordinate the deci- sions of utility-maximizing consumers and profit-maximizing producers so as to spontaneously generate an efficient allocation of resources. This efficiency is known as Pareto optimality, a situation where it is no longer possible to real- locate resources in such a way that we can make one person better off, with- out at the same time making someone else worse off.2This condition is to be reached under a competitive market without any sort of government interven- tion. However, most economists would agree that there are several factors contributing to the existence of market failures, among which are externalities.
An externality occurs when the decisions of an economic agent affect the decisions made by others directly rather than through market prices. In this case, the consumption of a consumer or the production of a producer has a direct effect on the consumption or production of others that is not reflected in the market price.3Costs borne by the agent conducting an economic activity are called private costs, while all costs imposed on other people by a consump- tion or production activity of that agent are called external costs. The sum of private costs and external costs is called social costs, reflecting all costs borne by society. An efficient level of output occurs when the price of a product is equal to the marginal social cost of production, that is, the marginal cost of private production plus the marginal social external cost. Inefficiency in the presence of externality is shown by the difference between private costs and social costs.4
Environmental problems are considered as a typical example of externality.
Environmental pollution and other environmental externalities are generally negative. They reflect the absence of markets (no exchange through supply and demand) and of market prices for (some) environmental resources or
1 See Chapter 10 in this volume.
2 Griffiths and Wall (2000, p. 431).
3 Pindyck and Rubenfield (2001, p. 592). However, effects on other people that directly result from market price are not considered as externality.
4 Solberg (1982, p. 540).
services.5Moreover, the prices of many resources often do not reflect the full costs involved in their use. In this regard, the use of environmental resources and its impacts have not been appropriately considered by the firm’s decision- makers. As a result, the firm will produce output that maximizes its private profit, regardless of the large external costs it potentially imposes on society.
Obviously, the case of externalities exhibits a situation where competitive unregulated markets lead to inefficiency.
The internalization of environmental externalities is the main objective of the polluter-pays principle.6Economists believe that only when external costs have been fully considered will firms act so as to prevent market failures and move to a socially optimal level of output.7Consequently, from an economic point of view, the existence of environmental law or policy should be primar- ily directed at remedying the externality, namely by forcing the firm to inter- nalize external costs in order to eliminate the difference between marginal social costs and marginal private costs.8The fact that in the absence of law there will be no adequate incentive for the firm to internalize the externality indicates that the goal of environmental law seems to be a simple one: to
5 Groosman (2001, p. 539).
6 One should bear in mind, however, that there could be cases where the exis- tence of environmental externalities cannot be traced back only to the polluter, but also to the victims. This issue has been raised by Ronald Coase, a Nobel Prize winner, who states that the traditional approach of striving to ameliorate externalities – referring to the Pigouvian approach – has tended to obscure the nature of choice by focusing on the reduction or avoidance of harm only on the side of potential polluter. This actually constitutes a mistake, since in reality we are dealing with a problem of a reciprocal nature, where we face various harms and thus we have to choose one solution where harm is the least. Hence, the main questions are whether or not pollution abatement will harm the firm, and whether or not such a reduction has a greater value than the value of what has been sacrificed to obtain it (the cost of pollution reduction). In his conclu- sion, referred to as the ‘Coase theorem’, Coase states that when parties can bargain together and settle their disagreements by cooperation, their behaviour will be efficient regardless of the underlying rule of law (Coase, 1960). Unfortunately, we do not have enough space to discuss this theorem more deeply.
7 Turner et al. (1994, p. 77).
8 In a competitive market, price (P) will be set equal to marginal private cost (MC). With the presence of externalities, MC will not reflect the true costs, since there are some costs that are externalized. Here, the true marginal costs (or marginal social costs – MSC) are the sum of MC and marginal external costs (MEC). Having taken into account the external costs, the new price should be set equal to MSC. Hence, with the internalization of the externality the price will be:
P = MSC = MC + MEC (Hunter et al. 1998, p. 108).
induce the potential polluter to take into account the pollution it might cause in its decision-making process.9
The polluter-pays principle has been adopted in several international conventions, among them:10the 1980 Athens Protocol for the Protection of the Mediterranean Sea against Pollution from Land-based Sources and Activities, the 1992 Helsinki Convention on the Transboundary Effects of Industrial Accidents, the 1993 Lugano Convention on Civil Liability for Damage result- ing from Activities Dangerous to the Environment, the 1992 Helsinki Convention on the Protection and Use of Transboundary Watercourses and International Lakes, the 1996 London Protocol to the Convention on the Prevention of Marine Pollution by Dumping of Wastes and Other Matter.
The principle has also been included in Principle 16 of the Rio Declaration, which reads as follows:
National authorities should endeavour to promote the internalization of environ- mental costs and the use of economic instruments, taking into account the approach that the polluter should, in principle, bear the cost of pollution, with due regard to the public interest and without distorting international trade and investment.
Although it has been quite widely recognized, there are several problems with the principle itself related to the clarity of certain terms. Clarity is of impor- tance, particularly when we need to make the principle applicable. This issue will be discussed in the following subsection.
9 Faure (2001, p. 10). However, when invoking environmental policy to over- come the externality, one should also bear in mind the possibility that this kind of government intervention might yield another form of inefficiency, or might even aggra- vate environmental degradation. Kerry Turner et al. conclude that, in some cases, it is the government that fails the environment, and not the market. This conclusion is based on the following reasons: first, at one extreme, governments may be interested only in pursuing their own interests, or at least favouring the interests of some section of the community rather than the whole. This means that governments may well not act to protect the environment, especially if they think that environmental protection will impose costs on the members of powerful pressure groups; secondly, governments may not be very good at getting the right information which enables them to trace the full consequences of a particular action; thirdly, even though government, in the form of politicians, may have good intentions and frame a good environmental law in princi- ple, their intentions still have to be translated into practice, involving experts as part of government bureaucracy. Since bureaucrats are very often not elected officials and tend not to be paid by results, they often have little incentive to behave in the best interests of the community unless they are closely controlled by the politicians. See Turner et al.
(1994, pp. 80–1). These arguments demonstrate that government intervention may be inefficient either because it is based on incomplete information or because it is carried out to pursue private, rather than public, interests.
10 De Sadeleer (2002, pp. 23–4).