Market Failures and Regulation: One Way Forward

This blog continues the commentary on how to get people to act in the face climate change and its impacts. Previous blog posts outlined why people don’t act and also presented the CLIMATE model as means to encourage action. A few weeks ago, I began discussing the “C” in the CLIMATE model and this blog continues to address the “L” for legal and public policy actions.

Most economists and analysts agree that markets are relatively efficient. They believe that for any initial allocation of resources—a  competitive process of exchange among individuals via input or output markets—will lead to economically efficient outcomes. A competitive system (i.e., a system built on the self-interested goals of consumers, producers, and transparent pricing) will achieve an efficient allocation of resources for all parties in the market. However, these outcomes may or may not be equitable.

In truth, competitive markets often fail for several reasons. I will discuss the most prominent reasons for market failure related to environmental sustainability and a few tactics that can offset these failures. These failures are critical to our conversation about environmental sustainability because market failures often occur when natural resources are not properly considered in business strategies. For example, the use of resources is not taken into account when prices are calculated.

Incomplete Information Can Cause Market Distortions. 

If consumers do not have complete information about a product or service, they cannot make suitable decisions. In the current market, there are regulations related to what companies must disclose about their products, but there is also information (e.g., environmental footprints and certain nutrition facts) that companies are not obligated to disclose. Incomplete information leads to adverse selection when products of different qualities are sold for a single price because buyers and sellers are not sufficiently informed to determine the true value.

A company’s reputation is critical when there is incomplete information; a lack of information forces consumers to trust the seller. Reputation is also important when buying products because we often buy a particular product based on what we know or feel about a company. Therefore, branding is a critical tool used by companies to communicate their reputation. In this way, branding becomes a means for overcoming market failure due to incomplete information.

When firms cannot market themselves based on reputation, they tend to use other means of letting customers know about their products, such as standardization. Creating standard ways to present a product or using common sales techniques, such as guarantees, helps consumers gain confidence that a product’s price accurately reflects its value. Sellers also use market signals such as quality seals.

Externalities: Unaccounted Costs.

Another reason for market failures is what economists call externalities or unaccounted costs. Sometimes, market prices do not reflect the activities of the producers or consumers. This occurs when a consumption or production activity has an indirect effect on other consumption or production activities not reflected directly in market prices; the cost is then absorbed external to the market that caused the cost. One of the most obvious examples of unaccounted costs impacting the environment is pollution. A chemical plant may dump waste into a stream causing downstream recreation sites to be unsuitable for use. In this case, the producer does not bear the true cost of this impact absent regulation.

There are many tactics for combating pollution that ultimately cut down on unaccounted costs. An emission standard, usually created by federal governments, provides a legal limit on how much pollution a firm can emit; if the firm exceeds it, it can face monetary or even criminal charges. The firm could install abatement equipment and procedures (or change inputs and production materials) if the fines and penalties are higher than the cost of abatement. Otherwise, the firm may delay expenditures to avoid unnecessary costs. Another technique is upfront fees that federal and state governments charge to force companies to make environmentally friendly decisions.

Different countries have different preferences as to how firms should absorb these costs. The United States tends to use standards, whereas countries such as Germany and Spain tend to use fees. For example, the U.S. Environmental Protection Agency (E.P.A.) has often provided specific pollution standards for various industries and provides incentives to buy renewable energy. On the other hand, the German government provides energy resource providers with incentives via a feed-in-tariff (i.e., energy distributors are required to pay a premium to renewable energy producers and purchase the energy source). The feed-in tariff is similar to a tax that encourages energy providers to use renewable energy sources.

Each technique depends on the ability of regulators to set accurate standards and balance the costs of compliance with the costs of noncompliance. When a government has limited information about the costs and benefits of pollution abatement, a standard or a fee could be preferable. Note that a standard is preferable when the marginal social cost curve is steep and the marginal cost curve is relatively flat (i.e., money spent per unit of emissions increases rapidly when the level of emissions increases, yet the marginal costs to producers does not change very much when the level of emissions changes).

Typical firm-level responses to regulatory and legal pressures are varied (e.g, avoid, reduce, adapt, and disregard). Firms may use all of these responses throughout their existences. Determining the correct response is dependent upon a myriad of factors (i.e., executive perceptions, company capabilities, and past experience with similar events). I have not discussed these responses, but more information can be found here. In another blog, I will consider why regulation exists and explore whether regulation has been effective in creating positive environmental outcomes.


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