Incentivization, Externality Pricing and Coasian Economics

Debate over the method to tackle environmental issues has been under debate since the eighteenth century, when Adam Smith came out with the Bible of Capitalism "The Wealth of Nations" whereby he argued an absolute free hand to markets with the firm belief that the markets will find the solution to every problem. This can be argued to be a novel position with respect to environmental issues, as till then laws were passed in England for curbing pollution (or at least the visual aspects of it). Though Marx and Engels did believe in the absolute control of the State, a middle path alternative to incentives and State control really turned up in the nineteen twenties, with A.L. Pigou coming out with arguably the Socialis't Holy Book, "The Economics of Welfare". He argued consistently for both aspects, saying that while it is okay for enterprises to make profits, to tackle problems arising due to industrial activities, profits must be taxed and the monies turned around to health welfare and pollution clean up activities. While the argument has been supported strongly by influential thinkers like Amory Lovins and Paul Hawken, and has seen considerable success in the case of Denmark's energy policy on the carbon tax front (I talked about it here) there are adequate concerns of breeding corruption and nepotism that tend to arise due to such arrangements as well as the reluctance to cut down on profits while inviting too much 'interference' from the government.

A position that heavily relied on the Adam Smith argument of market being the best way was put forward by Ronald Coase as an alternative to Pigou's taxation ideas in the nineteen thirties, and said that if trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. This argument clearly supported by people like Milton Friedman in recent times, believes that incentives come out of the market's own operations if the externalities that arise are tradeable in nature. This has been the foundation for most cap-and-trade scheme that ultimately pose faith in the market's ability to rectify its shortcomings, particularly the Emissions Trading schemes for acid rain gases and the greenhouse gases. While the idea does appeal to business heads and corporate honchos as it gives them an incentive in reducing their externalities by helping them benefit from actions that are 'good', there are numerous cases where such benefits go to people who do not need it at all. A classic case is that of the HCFC gas flaring being a project eligible for carbon credits, even though it was well known that these gases would in any case have to be phased out under the Montreal Protocol's provisions.

Another example of incentivizing actions has been through direct financial benefits being offered by the government. Under this scheme, the government doles out financial incentives to industries to undertake corrective mechanism, but then has been considerable debate whether such incentives work or not. There are an equal number of success and horror stories on either side of the debate that can confound people into saying - What the hell is going on? A recent example of the incentive scheme having gone horribly wrong is the case of female infanticide in Rajasthan, where the government's idea of encouraging child birth in hospitals through cash dole outs has become a cruel joke on the girl child (more on that here).

Neither mechanism is perfect is well understood. However to think that none of them is needed is also taking a ridiculously negative stance. The way ahead is to actually find ways wherein we see a gradual shift in policy making towards solving environmental problems. The path has to be a mix of voluntary Coasian mechanisms, followed by direct financing and eventual hardening of laws with taxation of externalities. This not only sees short term benefits of the Coasian mechanism being achieved, it also helps in the long run raise money for clean up activities through funds gained from taxation. A definitive timeline of less than 20 years is the suitable path in my opinion for undergoing such an evolution, and no budging or extensions is the correct approach for tackling environmental issues, as it also brings seriousness into the issue over a period of time.


Manish said…
Economics is the only means to effective policy design because no body is color blind to the kaleidoscope of cash, bravo!
True, policy is heavily dependent on economics.

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