This article was originally published by Timothy D. Terrell at The Mises Institute. 

In over twenty-five years of teaching undergraduate students, I have heard the same refrain countless times: free markets have many problems that government has to step in to solve. Indeed, students expect the government to “step in” so much that markets occupy a peripheral role in their idealized economic system. Even students with an ideological predilection toward markets will be quick to argue that certain problems, such as pollution, require extensive government regulation and probably copious spending of tax dollars.

This is not surprising, given that college students have been bombarded by tales of government fixes for social problems from media, teachers, and parents from elementary school onward. By the time they hear about “market failure” in their first economics class, it doesn’t take much convincing that free markets are impractical at best and a weak rationale for capitalist exploitation at worst. The best-selling economics textbooks at the university level do little to counter these perceptions, and most instructors won’t deviate much from the mainstream books.

Most principles of microeconomics and intermediate microeconomics textbooks devote at least one chapter to market failure, which typically includes “market power” (think monopoly), inadequate provision of “public goods” (goods that the private sector allegedly won’t produce enough of because of an inability to make the users pay), and “externalities” (the unintended side effects of human activity on bystanders, like pollution). While textbooks usually contain some acknowledgment of the fact that governments don’t live up to idealized models of efficiency, it is rare for proportional space to be devoted to “government failure” and easy for students to conclude that government intervention is the answer to these nearly ubiquitous shortcomings of markets.

The Apologists for Environmental Regulation

The problems with monopoly theory and the errors of mainstream thinking about public goods have been dealt with elsewhere. In my experience, externalities—typically, environmental problems—have proven one of the most difficult challenges for students trying to understand markets and government. Don’t pollution problems require government intervention?

Typically, the section on externalities contains a few diagrams showing the difference between private costs (or benefits) and social costs (or benefits). The diagram for negative externalities usually looks something like Figure 1, with the marginal private cost (MPC), marginal social cost (MSC), and marginal private benefit (MPB). Students are then directed to observe the difference between the optimal quantity of output (Q*) of the good that results in the negative externality and the quantity of output produced in the market (Q^M). Any production in excess of Q* adds more to costs than to benefits, creating a net loss labeled “deadweight loss.” The presence of this deadweight loss is deemed evidence of market failure, and the authors normally proceed to evaluate various ways government can push the market toward Q*.

Figure 1: The difference between costs and benefits of the quantity of output resulting in negative externalities

Walter Block has argued that there are problems with the usual treatment of externalities as market failure. If the recipient of pollution is unable to collect damages or procure an injunction from a court—the typical remedy prior to around the mid-nineteenth century—then this is not market failure, but the government’s failure to uphold property rights. Once reasonably diligent in their protection of property rights, the courts began weakening these protections in the mid-1800s. An example is the 1866 case Ryan v. New York Central Railroad Co. (35 N.Y. 210), in which a railroad was not held liable for the loss of a house that had been set on fire by sparks from the railroad’s nearby woodshed, which had burned down due to the company’s negligence. Even so, court protection retained some force long after. As Jonathan Adler pointed out, in a famous 1913 case in New York, Whalen v. Union Bag and Paper Co. (208 N.Y. 1), “the state’s highest court upheld an injunction shutting down a $1 million pulp mill employing several hundred workers in order to protect the riparian rights of a single farmer.”

As court-made law to settle conflicts over nuisances like pollution has been increasingly regarded as inadequate to deal with externalities, government interventions have typically taken three forms: (1) command-and-control regulation, (2) emissions taxes, and (3) cap-and-trade (tradable permit) systems.

Command-and-control regulation is unpopular with many economists because of its tendency to require emissions reductions in ways that are inflexible and therefore likely to be more costly. It is also particularly susceptible to “crony capitalism,” since industry lobbyists can push regulatory bureaucracies to mandate technologies that keep competitors out. Far more attractive to economists are emissions taxes and tradable permits.

Emissions taxes (sometimes called Pigovian taxes after the Cambridge economist Arthur Cecil Pigou, a student of Alfred Marshall) have gained new attention as a part of climate policy. Numerous proposals for a federal carbon tax have appeared in the last several years, including the “Green New Deal,” and even some who claim to be libertarians have proposed them. Tradable permit systems have been in use in the United States for decades, notably with the Environmental Protection Agency’s Acid Rain Program that began auctioning off sulfur dioxide permits in 1993. Tradable permit systems have a superficial appeal to market-friendly economists because, after all, the permits trade in a market. Unfortunately, it’s only a quasi-market, with the supply of permits dictated by regulators.

Most economists seem to favor one or the other of these policies. However, both emissions taxes and tradable permit schemes suffer from fatal problems.

The Pollution Calculation Problem

First, the government has no way to determine the costs inflicted by the pollution, whether for the purposes of setting a tax or creating a cap on emissions. Referring to the diagram in Figure 1, there is no way to find the MSC, which means that the government can’t know how high to set the tax, and a tradable permit system won’t have useful information about how many permits should be created.

This calculation problem has long been recognized. James Buchanan explained the problem in Cost and Choice:

Consider, first, the determination of the amount of the corrective tax that is to be imposed. This amount should equal the external costs that others than the decision-maker suffer as a consequence of decision. These costs are experienced by persons who may evaluate their own resultant utility losses. . . . In order to estimate the size of the corrective tax, however, some objective measurement must be placed on these external costs. But the analyst has no benchmark from which plausible estimates can be made. Since the persons who bear these “costs”—those who are externally affected—do not participate in the choice that generates the “costs,” there is simply no means of determining, even indirectly, the value that they place on the utility loss that might be avoided.

As Art Carden succinctly put it, “The information needed to know whether a particular regulation ‘works’ quite literally does not exist, and the key difference between firms and governments is that firms . . . have market tests for their decisions. Governments do not.”

However, economists and policymakers continue pretending the necessary information is within their reach or that the difficulty can be safely dismissed. William Baumol, writing in the top-ranked American Economic Review in 1972, admitted to the information problems in a defense of Pigovian taxes:

Despite the validity in principle of the tax-subsidy approach of the Pigouvian tradition, in practice it suffers from serious difficulties. For we do not know how to estimate the magnitudes of the social costs, the data needed to implement the Pigouvian tax-subsidy proposals. For example, a very substantial proportion of the cost of pollution is psychic; and even if we knew how to evaluate the psychic cost to some one individual we seem to have little hope of dealing with effects so widely diffused through the population.

Later he noted, “we do not know how to calculate the required taxes and subsidies and we do not know how to approximate them by trial and error.”

Unfortunately, Baumol essentially dismissed these problems and proposed acting “on the basis of a set of minimum standards of acceptability,” finding “some maximal level of this pollutant that is considered satisfactory.” This, of course, sweeps the information problem (how much is “acceptable” or “satisfactory”?) under the rug, which he admitted. “But,” Baumol contended, “if we permit ourselves to be paralyzed by councils of perfection we may have still greater cause for regret.” In other words, it is better to do something to reduce pollution than to impose no pollution limits whatsoever. Baumol, and those who still today advocate for emissions taxes or tradable permits, fail to see that even within their own problematic analytical framework, it is easily possible to overestimate the MSC and therefore “overcorrect” with taxes that are too high or emissions caps that are too low, thereby increasing instead of decreasing the size of the deadweight loss triangle (see figure 2). They also fail to appreciate the effectiveness of tort and nuisance law in preventing environmental trespasses. Murray Rothbard reminded us of the value of this decentralized, court-based approach (the common law) in his classic 1982 essay “Law, Property Rights, and Air Pollution.”

Figure 2: The effects on the quantity of output of overshooting taxes on negative externalities

Environmental (In)Justice

The second major problem is that neither emissions taxes nor tradable permits have a clear way to compensate the victims of pollution for the losses they continue to suffer. Fines, or the proceeds of permit auctions, go to the government, not to those who are enduring the pollution. Indeed, the entire apparatus of authoritarian environmental law that has developed over many years, whether command-and-control or some other type of regulation, has failed to protect the property rights of the neighbors of polluters. Mandating a scrubber on a coal-fired power plant or taxing sulfur dioxide does nothing to compensate someone who might still be adversely affected by the remaining emissions. Also, if emissions permit under tradable permit systems are exchanged among polluters in different areas, the emissions will shift from one polluter’s neighbors to another’s with no compensation to these victims of pollution. Justice, it would seem, would require the firm acquiring permits to increase compensation to its neighbors commensurate with the increased pollution it will emit, while the firm selling permits would reduce compensation to its neighbors. So, if property rights are protected, the firm acquiring permits would be paid by the firm providing the permits, since the acquirer is accepting the burden of compensating its neighbors. Yet, tradable emissions permit systems produce the opposite: the firm acquiring permits pays the firm providing them. The gains to some bystanders and the losses to others are regarded as irrelevant.

This presents significant ethical problems, though most mainstream economists seem willing to ignore them and pursue the elusive point of “social efficiency.” As Murray Rothbard pointed out in “Law, Property Rights, and Air Pollution,” “even if the concept of social efficiency were meaningful, they don’t answer the questions of why efficiency should be the overriding consideration in establishing legal principles or why externalities should be internalized above all other considerations.” Similarly, Robert McGee and Walter Block have argued that tradable emissions permits, despite some efficiency advantages over command-and-control regulation, “entail a fundamental and pervasive violation of property rights” and that this form of “market socialism” should be replaced with the aforementioned court-made common law that strictly preserves these rights.

Who Cares about Efficiency?

Even if we set aside the information problem and the ethical problem, it is not clear why we should expect government to pursue the most efficient outcome. Politicians and bureaucracies have their own objectives—typically, politicians want to be elected, and bureaucrats want larger budgets to play with. When faced with relentless pressure by lobbying groups who don’t particularly care about overall economic efficiency, politicians will happily disregard anything their economics professors said about marginal social cost. Environmentalist organizations won’t be inclined to stop asking for emissions cuts when Q*—even if we knew what it is—is reached. Natural gas producers will want carbon taxes high enough to disadvantage their coal competitors but not enough to drive electric utilities to nuclear energy. In such an environment of competing interest groups, the Q* textbook outcome would appear only by rare happenstance.

We would do well, then, to discard “efficiency-based” theories that make impossible demands for information and that rely on selflessness from government policymakers. As Ed Stringham and Mark White pointed out, following Murray Rothbard:

Utilitarian theories in general suffer from these calculation problems, but deontological theories, such as rights-based ethical systems, do not. In such theories, legal decisions would be made based on notions of justice rather than efficiency, and judges would not face the unenviable task of calculating the economic consequences, in all possible states of the world, of all their possible actions.

There are other problems with emissions taxes and tradable permit schemes apart from the several that I have mentioned here. For example, Bob Murphy has shown that even a “revenue-neutral” carbon tax is “likely . . . [to] impose more deadweight loss on the economy, offsetting at least some of the potential environmental benefits.” Furthermore, proposals for such a tax—which is, after all, a tax on capital—are full of misleading claims, and carbon taxes would be destructive to economic growth. Additionally, given that many of these proposals are intended to prevent damage that could theoretically occur in the distant future, we can know even less about the capabilities and priorities of these remote descendants of ours, and the costs could extend generations into the future before these possible benefits materialize.

Government can’t accomplish the improvement over market outcomes that emissions taxes and tradable emissions permits promise and could easily make matters worse. As we have seen, the government doesn’t have the information it would need to identify what level of pollution is efficient for an entire society, and government officials don’t have the incentives to be particularly interested in efficiency anyway. Dealing with environmental spillover effects on the basis of rights, rather than incoherent “social efficiency,” is more defensible, both practically and ethically. A new appreciation for liberty and the common law would go a long way toward recovering property rights protections and reducing pollution problems.