Overriding Consumer Preferences with Energy Regulations

July 23, 2013

The efficiency rationale for any government regulation rests on the existence of some type of market failure. The ways markets may fail are quite diverse, ranging from market structure to various kinds of external factors; that is, negative effects on parties other than the buyer and seller of a product. In the absence of some type of market failure there is no legitimate basis for regulation from the standpoint of enhancing economic efficiency, say Ted Gayer, the codirector of the Economic Studies program and the Joseph A. Pechman Senior Fellow at the Brookings Institution, and W. Kip Viscusi, Vanderbilt's first University Distinguished Professor, with primary appointments in the Department of Economics and the Owen Graduate School of Management as well as the Law School.

The most prominent economic justification for environmental policies is to remedy a market failure due to external factors, which do represent actual potential benefits of energy efficiency standards.

  • The classic example of an external factor is the release of air pollution as a byproduct of production of a marketable good.
  • The air pollution harms human health, but abatement raises the firm's production cost.
  • If the government clearly establishes a property right for the clean air, then depending on who owns the property right, either polluters would need to purchase the use of the air or the victims of pollution would need to pay polluters to reduce pollution.

The social costs of air pollution are internalized into the market decision, resulting in an economically efficient outcome.

  • However, high transaction costs frequently prevent the affected parties from reaching an efficient solution, especially in the case of air pollution in which large populations are exposed to pollution.
  • As a result, abatement is not undertaken since the production decision is made without considering the external harm to human health.
  • In these cases, more direct government intervention (whether through market-based instruments such as a pollution tax or through command-and-control regulations) can achieve the level of air-pollution reduction that increases net benefits to society.

Environmental policies can be most successful at maximizing net benefits (or at least improving net benefits relative to the nonintervention case) if they are designed after careful consideration of unbiased estimates of the costs and benefits of environmental quality.

Source: Ted Gayer and W. Kip Viscusi, "Overriding Consumer Preferences with Energy Regulations," Mercatus Center, July 10, 2012.

 

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