A Theoretical Analysis of Polluter-Pays Principle with ‘Allocated Costs’ between Economic Agents

Abstract

The aim of this paper is to clarify both original and extended definitions of “Polluter-Pays Principle,” point out the shortcomings of the theoretical analysis frequently used in environmental economics, and then build a simple general equilibrium model showing several ways of internalizing social costs emerged by pollution from production of goods, with an introduction of so called “allocated costs” between economic agents concerned. This is an economic attempt to determine whether the Polluter-Pays Principle could be held or modified depending on informational certainty about abatement costs. As a result of obtaining efficiency under the externalities, we will show four cases. A “Complete Polluter-Pays Principle” is required only if the social costs due to pollution are internalized by setting allocated and abatement costs properly and the latter are known to both the polluter and the pollutee exactly. On the other hand, when the pollutee does not know the abatement costs while the polluter does, they should bear the external costs fifty-fifty as the allocated ones, which can be interpreted as an “Equally-Pays Principle.” Moreover, it is interesting to note that a “Pays-and-Receives Principle” should be applied to the cost internalization when the pollutee overestimates the abatement costs. Finally, it is almost impossible to internalize the social costs without the allocated ones. Key Words : Polluter-Pays Principle, allocated cost, cost internalization, cost allocation JEL Classification Numbers : D62, H21, K32