For the general welfare, growth is arguably the most pressing of all economic issues. It is the one process that can raise living standards without letup and promise substantial reduction of the world's widespread poverty, which George Bernard Shaw rightly described as humanity's greatest crime. The pressing issue, then, is what can be done to stimulate economic growth substantially or at least to preclude its decline?

Just a few years ago many of us thought that we had the answer, and that the answer was obvious. When the Soviet empire collapsed it seemed clear that the magic formula was contained in one word: “capitalism.” After all, no small role in the collapse was played by the poverty of the Soviet economy, and its resulting inability to keep up with the West. This, along with envy of the economic miracles that so many capitalist nations had been able to produce, were all obviously attributable to rejection of the capitalist system by the communist regimes, or so it seemed. However, this conclusion is only partly true, and even when true, the story requires some nuance (Schramm 2004). The decade of disappointing economic performance in Russia and the repeated economic crises in Latin America and other such phenomena clearly must give us pause. In our book, Good Capitalism, Bad Capitalism, we offer what we believe to be the explanation. Capitalism is not a homogeneous animal. The term represents a number of species.

Though we were both graduate students at the LSE, Bill Phillips arrived after I had left. Hence, I only met him after he had already joined the faculty. Even at our first meeting his delightful personality, kindliness and quick mind were all immediately evident. I can therefore say that I knew him, and that it is an enormous pleasure to be able to contribute to his Collected Works.

In chapter 16, a remarkable essay that emerged from his dissertation, Bill Phillips demonstrated that automatic stabilisation policies can exacerbate instability rather than contain it. Moreover, an adjustment of the parameters governing such a programme in the directions that common sense would suggest may well worsen the problem. The essay also offers an intuitive description of one process that can be taken to underlie the Phillips Curve. In addition, such a graph is drawn in the paper, though it is based neither on empirical data nor on any formal model. Nor does the discussion offer anything that can be used directly to meet the later monetarist challenge claiming to have demonstrated that in the long run the Phillips Curve must be vertical at ‘the natural rate of unemployment’.

Those destabilising stabilisation policies

When, in 1960, I was writing my article, ‘Pitfalls in Contracyclical Policies…’, I was not aware that a paper demonstrating my main con- clusions had already appeared in print six years earlier. The fault is only partly mine, for, with his usual modesty, Bill Phillips has eschewed melo- dramatics in describing these results.

The very stimulating paper by Skaperdas and Syropoulos (henceforth S&S) accomplishes many things. It extends the formal analysis of the economics of crime yet another step and shows once again how powerful and suggestive the economist's tools have become, even outside the discipline's traditional realm. The article shows, in particular, that it is useful in an analysis of one side of their operations to think of criminal organisations as quasi-governments, serving in lieu of the state in arenas into which governments fear to tread, and in other areas forcing government by the state to let itself be replaced by the gang in some of the tasks of governance. Finally, the paper stimulates the reader to venture into new directions, as these few comments will illustrate.

The basic point of the article is obviously valid, and obvious only in retrospect. The distinguishing feature of crime that is organised is, of course, the fact that it is controlled and directed by a group whose role is far more than just administrative. In particular, it determines the rules that the gang members will be expected to follow, and it adopts procedures designed to enforce those rules. Thus, the gang leadership takes on legislative and judicial tasks, in addition to its administrative activities and, by virtue of these undertakings, it becomes a government. One can easily see what other governmental roles it plays, entailing such activities as warfare, diplomacy, the provision of employment and welfare benefits to its members, etc. In places where ‘legitimate government’ abdicates its role, or is simply prevented by circumstances from performing it, organised gangs frequently spring up and fill the gap.

The Stockholm School and its vital contribution to sequence analysis played a key role in the transition of economic dynamics from the intuitive approaches of earlier business cycle theory to the powerful and rigorous analytics that is the hallmark of theoretical writings in the area since World War II. Erik Lundberg provided a vital contribution to this evolution. Though formal dynamic models had been contributed earlier by Ragnar Frisch, Lundberg's research showed well before Paul Samuelson's profound contributions on the subject how such models could be grounded firmly in the logic of sequence analysis and the pertinent macroeconomic considerations.

Lundberg's basic contribution to the field does not make any use of the now commonplace mathematical tools that sometimes offer general solutions to dynamic relationships; instead, it relies on numerical time sequences generated with the aid of particular illustrative values of the parameters of his dynamic equations. But I will show that this is not as restrictive a procedure as it may appear to be. Rather, there is a trade-off between the abstraction and deemphasis of the details of the underlying economic processes that the more formal procedures engender and the insights offered by the painstaking calculations that are vital for Lundberg's numerical time paths. Indeed, it will be pointed out that the ostensible superiority of the formal approaches in terms of the greater generality of their results is to a considerable degree an illusion, because the mathematical techniques are fully effective in providing analytic solutions for dynamic models only when those models take the most elementary (linear) forms.

Earlier, perhaps somewhat too much was claimed for the achievements of the Stockholm School. The danger now is a reaction that goes much too far the other way. The issue is not whether all of of the Keynesian model had been anticipated and laid out clearly before the appearance of the General Theory. Of course, the two sets of writing differed in content and in approach, so that while there was overlap, neither can be deemed a replication of the other. And in any event, it seems to me that argument over the proper assignment of priority a half century earlier is not a terribly significant exercise.

Rather, it seems clear that the Stockholm School did make a contribution to ways of thinking about macroproblems that was important and that was uniquely its own. The way of analyzing intertemporal developments that emerged in Sweden in the 1930s made it necessary for the entire discipline to revise its approach to the pertinent subjects. The formal dynamic literature that flourished in the early postwar period and is reemerging now owed little to Sweden in terms of its formal mathematics. But in terms of understanding why the models behaved as they did and how well they did or did not illuminate reality, all of us owe a heavy debt to the earlier Swedish writers, perhaps Erik Lundberg most notably.

Since the publication of the first edition of this book in 1975, there have been several important contributions both to the theory of externalities and to the design of policy instruments making use of economic incentives for environmental management. Perhaps most important has been the emergence of instruments that control quantity directly rather than through price adjustments; these measures represent an alternative to the standard Pigouvian prescription for a unit tax on activities with detrimental external effects. Since publication of the seminal paper by Martin Weitzman, economists have explored the properties of a system under which the regulatory authority issues a limited number of transferable permits. This work has shown that in a setting of uncertainty, the expected gain in welfare may be higher or lower under such a permit system than under a tax regime, depending on the shapes of the control cost and damage functions. The choice of one system over the other thus depends on the way damages and control costs change with the level of pollution.

At the same time, there has been growing interest at the policy level in the use of transferable permit systems for the attainment of our environmental standards. In the United States, the Environmental Protection Agency has introduced the Emissions Trading Program for the regulation of air quality; this program allows polluters (subject to certain restrictions) to trade emissions entitlements. Environmental economists have studied emissions trading and have, more generally, investigated the properties of a number of variants of transferable permit systems.

In this chapter we examine the direction of the bias produced by externalities. Is it true, as often asserted, that when an activity generates external benefits, its competitive equilibrium level will always be below its optimum, and that where an activity imposes external costs, its equilibrium level must be excessive?

This is a proposition that underlies much of the policy advice given by economists on externalities issues: allocate more resources to goods that yield beneficial externalities and reduce their allocation to those that generate detrimental externalities. But suppose that advice is not always correct – what do such exceptions imply about the economist's advisory role?

As a matter of pure theory this problem is not as serious as the one discussed in the next chapter, for the difficulty we are considering here does not undermine the Pigouvian tax-subsidy solution. So long as the appropriate convexity conditions hold and the economy is competitive, one need merely impose the appropriate tax rates and the market equilibrium must occur at a Pareto optimum, wherever it may lie in relation to the equilibrium that would hold in the absence of Pigouvian taxes.

In practice, however, as will be emphasized in Part II, we do not know how to find or perhaps even to approximate optimal tax rates and so considerably coarser policy measures must be utilized. Usually these rely heavily on the conventional wisdom that constitutes the subject of this chapter: the acceptance of the view that one should expand outputs that yield beneficial externalities, and conversely.

The preceding chapter explored the difficult issues that arise for the design of environmental policy in an international setting, issues whose source is, in part, the absence of an international agency with the authority to make decisions that can internalize the costs that nations impose on one another. This chapter returns to purely domestic issues, concerning itself with the choice of the appropriate authority for environmental decision-making. In particular, we ask whether it is preferable to delegate the determination of standards for environmental quality to regional (or “local”) governments or to rely on a national environmental agency to set uniform standards for environmental quality that apply throughout the nation.

Current policy exhibits considerable ambivalence on this matter. In the United States, for example, the Congress, under the Clean Air Act, directed the U.S. Environmental Protection Agency to set national standards for ambient air quality. The EPA responded by defining maximum allowable concentrations for six so-called “criteria” air pollutants applicable to all areas of the country. In contrast, under the Clean Water Act, the individual states have responsibility for setting water quality standards. U.S. policy thus relies on uniform national (minimum) standards for air quality, but state-specific standards for water quality. Which approach, a national or a decentralized determination of environmental standards, is the appropriate one?

The results of this chapter suggest that the answer to this question is not simply one or the other approach. Instead, the analysis points to the need both for centralized and decentralized participation in the setting of environmental standards.

This chapter seeks to show that, in addition to the pricing measures advocated in the preceding chapters, there is room in a well-designed environmental policy for at least one instrument that has attracted virtually no defenders among economists – the direct controls, so popular outside the profession.

After the demonstration in the preceding chapters that pricing methods have important efficiency advantages over direct controls, our advocacy of the use of the latter may appear somewhat inconsistent. However, we are not suggesting that the preceding discussion is basically incorrect, but rather that it omits an important consideration. Environmental problems do not always develop smoothly and gradually. Instead, they are often characterized by infrequent but more or less serious crises whose timing is unpredictable. Such emergencies may require rapid temporary changes in the rules of the control mechanism, and it is here that pricing measures appear subject to some severe practical limitations. In this chapter, we will show how the uncertainty associated with environmental conditions greatly complicates the implementation of a program of fees or subsidies.

We will not conclude from this that such programs are useless. We still believe that they have an important role to play and that economists have been right in trying to convince policy makers of their advantages. Rather, we suggest that the ideal policy package contains a mixture of instruments, with taxes, marketable permits, direct controls, and even moral suasion each used in certain circumstances to regulate the sources of environmental damage.

At least from a reading of the newspapers, one gets the impression that environmental policies are an issue in which income class plays a significant role. The poor and the wealthy seem to assign different degrees of priority to environmental protection: the proposed construction of an oil refinery is likely to produce anguished cries from middle- and upper-income inhabitants of a potential site and yet be welcomed as a source of more remunerative jobs by residents whose earnings are low. Similarly, proposals to ban DDT have been received with somewhat less enthusiasm in underdeveloped countries than they have encountered in the wealthier nations. This should, of course, come as little surprise to an economist. Assuming environmental quality to be a normal good, we would expect that wealthier individuals would want to “buy” more of it.

In addition to these differences in the demand for environmental quality, distributive elements also enter when we consider how the costs of a policy of environmental protection are likely to be distributed among individuals with differing incomes. To reach firm conclusions on so broad a subject is difficult, because the methods that are used to finance such policies vary widely. Nevertheless, by making some reasonable assumptions and exploring the available evidence, environmental economists have made some estimates of the incidence of these costs.

Obviously, the distributive side of externalities policy is of interest in and of itself in a world in which inequality and poverty have assumed high priority among social issues.

In Chapter 4 we derived our results for optimal taxes and payments from a competitive model in which individuals and firms both behave as price-takers. In this framework, prices and our prescribed fees are parameters for individual decision-makers; they take them as given and simply respond so as to maximize utility or profit.

In this chapter, we consider some of the complications that market imperfections introduce into the analysis. More specifically, we will examine the implications of two sources of such imperfections. First, a firm that generates externalities (smoke emissions) may not sell its output in a competitive market. For example, we will consider how a profit-maximizing monopolist will respond to the Pigouvian taxes prescribed in Chapter 4. We will show that an emissions tax rate that is appropriate for the pure competitor will not, in general, induce behavior that is consistent with optimality in the second-best world inhabited by a monopolist.

We then consider a second source of imperfection: the presence of polluters who are not “fee-takers.” There can be situations involving few polluters, the manipulation of whose activity levels can influence the unit tax paid on waste emissions. In such cases, we will see that producers (and perhaps also consumers) of externalities will have an incentive to adjust their behavior so as to influence not only their tax bills, but also the tax rate they pay per unit of pollution. As for the monopolist, this necessitates some modifications in the prescription for an optimal fee.

This book is one of a pair of companion volumes devoted to the study of economic policies to enhance the quality of life. Our willingness to embark on so considerable a subject only reflects our conviction that economists as a body have already made sufficient headway on these problems to make such an undertaking worthwhile. We believe, in short, that this is a subject on which economists have a great deal to say that is useful; these books are intended both to bring that material together and to carry the investigation some stages further.

This volume is primarily theoretical and is consequently addressed to our fellow economists. However, it is not meant to be theory for theory's sake. Here our prime concern is policy; we are interested in the theory as a means of understanding the complexities of environmental programs.

The orientation of the other book is primarily empirical; there we will present and evaluate pertinent data and experience for guidance in the choice of policies for environmental protection and for the improvement of other aspects of the quality of life. Though it will be less technical than the theoretical volume and will consequently address itself to a broader audience, we intend it to provide the empirical counterpart to the theoretical structure developed in this book.

Our most direct debt is that to the National Science Foundation, whose support has made our work on the two volumes possible.

The results arrived at in Chapter 8 may seem to constitute insuperable barriers to a rational environmental policy. The very presence of externalities is likely to produce a large number of local maxima among which, in practice, it seems impossible to choose with any degree of confidence; we may not even know in which direction to modify the level of an externality-generating activity if we want to move toward an optimum. It should be emphasized that these problems beset equally all attempts to achieve optimality by any of the means usually proposed – direct controls and centralized decision-making at one extreme and pricing schemes, such as the Pigouvian taxes and subsidies, at the other.

Nevertheless, we believe that it is possible to design policies for the control of externalities that are reasonably efficient. The approach that we will propose in this and the next chapter consists of the use of a set of standards that serve as targets for environmental quality coupled with fiscal measures and other complementary instruments used as means to attain these standards. The standards, while admittedly somewhat arbitrary, are, in principle, not unlike the growth or employment goals that have guided governmental macroeconomic policies. In both cases, employment and environmental policy, the approach is, in practice, basically of the “satisficing” variety, with acceptability standards based on individual judgments and, often, compromise. Yet, in both cases, the choice of effective means to achieve the established goals has been facilitated by a substantial body of economic theory. This theory suggests that fiscal measures can contribute to the efficiency of a program to control externalities. Moreover, the use of these fiscal measures in combination with standards for acceptable environmental quality, avoids, at least in part, the policy problems that have been raised in Chapters 7 and 8.