On environmental economics: Mandates vs. markets

^{The subtitle of this essay has been borrowed from Terry L. Anderson’s conference on ‘Markets vs. Mandates. Promoting Environmental Quality and Economic Prosperity’, Hoover Institution, Stanford University, Jan. 30, 2023. Permission granted.}

Take Away

The scarcity of means to satisfy given ends is an omnipresent condition of life and all conscious human actions profoundly affect the environment as they involve not only choices or trade-offs. At all times incentives also determine how nature’s resources are allocated and used. Whatever humble decisions we reach in our daily routine they will leave traces and footprints. Environmental problems thus are challenging, convoluted and typically defy simple solutions. Most likely due to the distinctly complex character of the problems connected with nature, it always was and today more than ever is implicitly taken for granted that people’s imputed selfish actions lack perception and prudence. The somewhat rash conclusion therefore is that individuals can neither be trusted with the protection nor the conservation of their natural surroundings.

Is there a greater tragedy imaginable that, in our endeavor consciously to shape our future in accordance with high ideals, we should in fact unwittingly produce the very opposite of what we have been striving for?

Friedrich A. von Hayek

Overconsumption

Policies aimed at the protection or the control of the natural world and its riches can easily be traced back far beyond Roman times.  Throughout the ages, in essence these measures were primarily intended to both regulate resource utilization and govern the relationship between citizens and the ever-changing ecological conditions. Now and then, they were also designed to improve sanitary quality.

Most likely due to the distinctly complex character of the environment it always was and today more than ever is implicitly taken for granted that people imputed selfish actions lack perception and prudence. The somewhat rash conclusion therefore is that individuals can neither be trusted with the protection nor the conservation of their natural surroundings. Moreover, this claim asserts that their self-interested behavior almost unavoidably will also trigger the Tragedy of the Commons. According to G. Hardin (1915-2003) who coined this famous expression, these ‘socially suboptimal’ situations occur whenever materialistic people deplete natural resources to their advantage without considering the well-being of a group or society as a whole. In other words, it is implied that people act contrary to the so-called common good, a mantra that is elusively defined as neither excludable nor rival in consumption or usage.

There is no doubt that the lack of clear ownership can tempt individual parties to an overconsumption of their reasonable share and their actions thus might well create costs that other people ultimately have to bear. However, before diagnosing the tragedy of the commons and the many hazards externalities may cause, it is indispensable to take into account the underlying institutional arrangements and the absence of property rights in particular. Overfishing certain areas of the oceans that are deficient of defined property rights or our daily experience with traffic congestions on public roads that do not charge tolls could serve here as examples.

Governments disregard risks

Detached from whichever political or economic system, our life will have an effect on the land, air and water around us and subsequently will also prompt external effects or externalities, either downwind or downstream. Most of them are set off by the absence or the incompleteness of property rights. Nonetheless, they can also be generated by the inability of policy makers to produce the politically popular common good. Unlike favorable or positive effects, pollution and other environmental hazards thus become essentially visible as negative externalities, because they impose a cost in any form on other people’s properties or personal space. The expected collective benefit from ecological protection or conservation measures is typically presumed to be the sole responsibilities of governments or municipalities. In other words, only benevolent politicians are considered able to devise ways and means of correcting the impact of human activities on the environment and of protecting biodiversity or natural resources (including wildlife, oil, water, etc.).

These allegations have effectively been contradicted by checking the evidence. Not only is it well documented that the worst and by far the most tragic environmental disasters were regularly triggered either by nature itself, by acts of war, by state controlled power plants or institutions in the public domain. There is also ample proof that for short-term political gains lobbies or governments even today often disregard known dangers and risks, while keeping the ignorant public in the dark. And yet, the majority of economic textbooks either introductory or advanced level, but above all the current pervasive popular narrative is quick to identify capitalism as the main culprit of the destruction of nature, borne by the many with large profits enjoyed by the few.

It must be noted here, that it was Ronald Coase (1910-2013, Nobel Prize 1991) who explained that absent transaction costs, externality problems can effectively only be traded away in unhampered markets.  In his groundbreaking work on ‘The Problem of Social Cost’ (1960), he not only showed that simply taxing or subsidizing various activities based on who caused them would most certainly not lead to efficient results. He also proved that rather than trying to replicate some theoretical ideal market situations through taxes or subsidies, governments should consider means of reducing transaction costs.

Alarmed by frantic and partly unsubstantiated stories, mostly without checking the basic facts opinion leaders or politicians proclaim environmental catastrophes or climate change as sure indications of market failures that require urgent actions.  Market failures are frequently not only used as justification for all kinds of government interventions. They are also blamed for encouraging the exploitation of shared resources. In other words, individual freedom, private ownership or free markets are held responsible for acting detrimental to the ambiguous idea of the common good.

However, if markets are mistakenly and even deviously judged against the unrealistic theories of market equilibrium or perfect competition one will by necessity arrive at rather distorting conclusions. Just as the textbook perfect competition model is an unthinkable ideal that has nothing to do with the real world, believing markets to be in an equilibrium or even in perfect order through state intervention requires highly questionable assumptions about governments and the wisdom of a collective. Markets are processes and at all times in a state of flux due to the necessary incomplete knowledge. Poor results arise not because markets fail, but because they are not present. Markets may not be a flawless solution for or in all conceivable conditions, we should nonetheless permit them to work where they are clearly superior. It seems useful to recall here Heraclitus’ (c. 535 BC-475 BC) famous insight that all things move and nothing remains static.

Decisive stumbling block

In perpetuity thus, it seems that we are challenged to internalize all externalities and have for the most part simply two options.

On the one hand we can be forced to adjust our behavior and mindset by government issued command and control measures with complex and almost inevitably ever-tighter regulations with socially and ecologically doubtful outcomes. Due to their qualities these regulatory methods are quite rigid and focus more on current problems rather than long-term solutions. Accordingly, systems using mandates tend to develop autocratic approaches that will in all likelihood get in conflict with existing constitutional-, civil- or property rights. As an example: without resorting to repressive measures, how would a central authority ever be able to decide on a socially optimal level of pollution or how would a bureaucracy determine the right amount of pesticides spread on unlike fields at what time?

Most command and control rulings and instruments seem to ignore Friedrich A. von Hayek’s seminal insight that knowledge in a society is widely dispersed and thus can never be given to anyone in its totality. According to Hayek (1899-1992, Nobel Prize 1974) it is especially the tacit individual ‘knowledge of the particular circumstances of time and place’, which facilitates effective nature protection. In other words, the information required to protect or allocate resources depends on these very specific circumstances of time and place and the spontaneous distribution of it among the many supersedes the special knowledge of the few. Whereas markets are decentralized collectors of knowledge, government command and control rulings are far from being omniscient or benevolent resources for an effective environmental policy.

Especially this point seems to be the decisive stumbling block that gets in the way of traditional command and control approaches to a successful environmental policy. Due to the fact that central governments, remotely acting supervisory bodies or even UN sponsored multinational scientific committees will never comprehend the knowledge ‘of the particular circumstances of time and place’. Their attempts to control pollution, let alone ‘climate change’ thus tend to be repressive or ill-fated. After all, a wealth of knowledge does not always teach men to be wise.

It should also be mentioned here that F.A. von Hayek perceives the existence of so-called ‘neighborhood effects’ as providing openings for governments to helpfully intervene into environmental affairs, taking expedient measures to restrict external harms or to facilitate the provision of vital public goods at reasonable cost. Hayek’s insights can point the way toward a policy approach that takes both markets and environmental problems seriously.

Private entrepreneurs are more responsive to environmental demands

The extensive research of scholars like Terry L. Anderson, Dominic Parker  or P.J. Hill ( and many more), clearly provides evidence that we have also a second, more promising option. We can use property rights, markets and entrepreneurship to effectively deal with most environmental hazards or limited resources and scarcity as an omnipresent condition of life. In their approach, fully enforceable property rights are considered an asset rather than a liability by giving owners an incentive for sustainable care. These entitlements typically entail the right to exchange property by mutual agreement and compel owners to account for the costs and benefits of their actions and thus facilitate market transactions that generate efficiency-enhancing gains from trade.  After all, the preservation of an owner’s value of his/her property at all times depends on prudent stewardship.

Provided, we consent to the Rule of Law as the backbone of democracy with well-defined property rights and entitlements that are easily defendable against all forms of environmental trespassing, individuals, groups or firms, whether as potential polluters or potential sufferers would naturally have a strong motivation to avoid such problems. Individual freedom and unhampered markets allied with accountability and ‘divestibility’ will innately generate those powerful incentives we need in order to reduce pollution, encourage nature conservation and environmental stewardship. When air, water or noise pollution harms a privately owned asset, the owner whose property is threatened will gain by reclaiming the status quo ante. These constraints set significant limits on the kinds of policies that can properly be pursued from bottom-up, not from top-down. In addition, private entrepreneurs are regularly faster and more responsive to environmental or social demands and needs than governments. Defined and enforceable property rights and competition thus create incentives that decrease deforestation, reduce levels of pollution and lead to an overall improvement in environmental quality. Policies that undermine or pass over these conditions — for example, by fixing prices or centralizing natural resource management under bureaucratic control — warrant a dynamic resistance, which often leads to detrimental activities and behaviors even when we foresee the specific bad consequences of adopting them.

By and large, any effective environmental policy in a free democratic society depends on a legal framework of institutions that safeguard not only private property and the rules guiding an individual’s interests and the consequences of her/his actions. In order to work for the benefit of all, it also depends on the decentralization of economic decision-making and on a market price system free of political manipulation. After all, markets may not be the perfect solution for or in all conceivable conditions, we should nonetheless permit them to work where they are clearly superior.