Economic instruments can be defined as mechanisms that force economic agents to internalize all or part of the social costs associated with environmentally harmful activities and that rely on market forces to promote efficiency. In doing so, they seek to impose additional costs on producers that harm the environment and reward those that improve environment outcomes, while utilizing market forces to improve the allocation of resources. (Some analysts include subsidies among economic instruments but as they are voluntary and economic agents are not forced to internalize the social costs they are more appropriately classified as voluntary instruments.)
This approach to environmental protection is usually associated with environmental economics, a school of economic thought that is a subdiscipline of neoclassical economics. According to environmental economists, environmental problems arise because of the existence of externalities - impacts involuntarily incurred by a person or persons without compensation or payment as a result of the actions of another. Because of the existence of externalities, markets are unable to guarantee the efficient allocation of resources. For example, if producers emit pollution into the atmosphere without paying for it, the price that consumers pay for the producers' outputs will not reflect the full social cost ofthe transaction. As a result, there will be excessive output and consumption of the relevant good or service. If producers are forced to internalize the social costs associated with the air pollution, there would be a more efficient tradeoffbetween air pollution and output, leading to higher net social welfare.
The more recent trend in environmental economics has been to characterize environmental problems as being a product of the incomplete allocation of property rights. According to this approach, if a property right over the relevant environmental resource were appropriately defined and allocated to individuals, and there was perfect information and no transaction costs, the operation of market forces would lead to efficient outcomes. For example, if the atmosphere were owned by someone and producers had to pay to emit pollution, then negotiation between the owner and producers would ensure the most efficient allocation of atmospheric resources.On the basis of these theories, economic instruments either
• require polluters to pay for all or part of the costs associated with pollution (e.g., pollution fees, individual liability, and removal of subsidies that promote overuse);
• place a restriction on the amount of pollution that can be emitted or resource that can be used and then allow pollution or resource entitlements to be traded among economic agents (called 'marketable permit' or 'cap-and-trade' schemes, e.g., tradable emission, water, catch and development rights schemes); or
• seek to create well-defined, secure, and transferable property rights over environmental resources and allocate these to relevant individuals or groups ('pure property rights' approaches, e.g., land titles and fishing area rights).
Marketable permit schemes and pure property rights approaches are similar in that both rely on the creation and exchange ofproperty rights to promote environmental and economic outcomes. But pure property rights approaches place no external restrictions on the use of the relevant resource and rely on market incentives to achieve the desired environmental outcome, while marketable permit schemes rely on a cap or limit on the use of the relevant resource to achieve the desired environmental outcome.
One of the major benefits associated with economic instruments is that by utilizing market forces they can encourage a more efficient allocation of resources. For example, when tradable emission quotas are used, the operation of market forces should ensure that the necessary emission reductions are achieved at least cost (i.e., the equimarginal principle should be satisfied). Further, economic instruments provide an incentive for producers to reduce pollution, which encourages innovation. Advocates of economic instruments also claim they are more flexible than regulatory instruments, although this is not always the case.
Although economic instruments can be more efficient than alternative policy mechanisms, they can suffer from a number of weaknesses. In relation to pollution fees, individual liability and pure property rights approaches, there can be a considerable amount of uncertainty associated with environmental outcomes. For example, producers may choose to absorb the increase in costs associated with a pollution fee, or demand may be unresponsive to price rises, meaning the level ofpollution may not decline by the desired amount. Consequently, where policy-makers are faced with uncertainty regarding environmental risks and questions regarding irreversibil-ity, alternative approaches can be preferable.
Like regulatory approaches, marketable permit schemes (or cap-and-trade approaches) can place an upper limit on the permissible amount of pollution or resource extraction. Hence, they can be useful in dealing with uncertainty and threshold effects. The advantage that marketable permit schemes offer is that having set a specified limit on pollution or resource extraction, they allow market forces to determine the allocation of pollution or extraction rights among producers. One of the most successful marketable pollution permit schemes has been the United States Environmental Protection Agency's Sulfur Dioxide Program, which is part of the broader Acid Rain Program. The cost of reducing emissions was substantially lower than predicted because producers had an incentive to find cheaper ways to do so.
Problems arise with marketable permit schemes when there is a lack of equivalence between the environment or pollution units that producers are expected to trade (i.e., the resource is not homogeneous). For example, tradable development permit schemes that place a limit on the amount of development in an area but allow developers to exchange development rights can lead to the rights moving toward the developments with the highest economic returns. However, they will not necessarily achieve biodiversity objectives as each parcel of land may contain different biodiversity values. Similar problems can arise with emission schemes that allow emission permits to be generated through the enhancement of sinks (i.e., there can be uncertainty about whether the enhancement of sinks will offset the additional emissions).
Transaction costs can also pose problems for economic instruments. Devising schemes that can be administered in a cost-effective manner can sometimes be difficult.
Further, if there are excessive costs associated with the negotiation and exchange of marketable permits, the efficiency benefits may not materialize.
As with all environmental policy mechanisms, politics can impede the effective use of economic instruments. However, economic instruments can be especially vulnerable to political influences if it is necessary to constantly adjust the price signals provided through the scheme. For example, if a carbon tax is used to address climate change, it will be necessary to adjust the tax over time to account for unexpected events and new information. Special interest groups may impede this process, thereby undermining the efficacy of the tax.
There has been a tendency in the past for regulatory instruments and economic instruments to be presented as substitutes. In practice, these two types of instruments are generally used as complements and economic instruments always require a regulatory framework. Indeed, there is a growing recognition of the need for policy packages or policy mixes that use a range of instruments to achieve environmental protection objectives.
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