External costs: Myth or rationale for state intervention?

Abstract

The paper considers the extent to which problems of environmental pollution can be left to the market system. The concept of external cost is used to establish the presumption that market forces will lead to excessive pollution. The performance criterion, that of Pareto efficiency, leading to this presumption is discussed. It is shown that for significant problems of pollution it is not possible to limit the role of the state to that of re-defining property rights. What is necessary is state intervention by way of the taxing, or regulation, of discharges into the environment: where external effects are undepletable, markets cannot meet the requirements of Pareto efficiency. Government intervention to meet such requirements requires that the government has information which is, in practice, either unavailable or very costly. Intervention towards more restricted goals is discussed. It is shown that arguments to the effect that the role of the state can be restricted to defining private property rights are based on assumptions which are irrelevant to significant problems. In particular, it is argued that a recent publication by the Institute of Economic Affairs does not, as claimed, show either that external costs do not exist, or that they exist but imply a minor role for the state in the protection of the natural environment.