Imagine a large lake surrounded by hundreds of private homes. If just one of the houses dumped its raw sewage into the lake, the capacity of the lake could probably absorb the affluent with no serious damage, although floating debris could be annoying. After all, it is a large lake and we are talking about the waste from just one family. How could this possibly be a problem? Well, maybe the lake has the capacity to absorb the affluent from one family, but what about all the houses around the lake? What if they all dumped their sewage into the lake? Clearly, this would be a problem. Without some type of intervention by the home owner’s association or government, there is no economic motivation for families to capture and treat their sewage. It is much less expensive to just run a pipe into the lake than it is to dig up the yard and install a septic tank and leaching field.
The story of the lake surrounded by houses demonstrates on a micro scale what ecologist Garret Hardin describes as “The Tragedy of the Commons". It is in the interest of all the homeowners to maintain the beauty of the lake and protect it from pollutants of all types, not just sewage, yet when each of the home owners act in their own self-interest and ignores the common good, the shared resource is eventually damaged or even destroyed, to the detriment of everybody. If the lake pollution continued unchecked, then the lake-front homeowners would start selling their properties since they would be less desirable, but there would be few buyers for houses on a polluted lake. Property values would rapidly decline and all the homeowners would take a significant financial loss.
The Tragedy of the Commons could be avoided and the lake preserved if only the homeowners consider the good of the community over their own self-interests. The fact that they don’t, illustrates one of the principal failings of free markets. Markets are wonderful things. Markets enable us to efficiently allocate resources and give us far more consumer choices, but when manufacturers and retailers fail to include the costs of pollution and resource deletion in the prices they charge, we end up misallocating resources. Pollution and resource depletion are costs that someone will eventually have to pay (maybe our children or grandchildren), but since they are not directly included in the prices we pay at the store, they are ignored as we make our purchases and therefore they are ignored by the free market.
In the case of the lake, a regulation that required everyone to have a qualifying septic tank and leaching field would likely protect the lake. The problem with regulations is that they can be complicated and difficult to enforce. Nobody likes regulations. The regulation would have to say how big the septic tank should be, and the minimum size should probably scale somewhat with the size of the house. Six bedroom houses should have a larger tank than two bedroom houses. The size of the leaching field will depend on the porosity of the soil, which can vary from site to site. Materials and construction techniques would need to be specified so that the septic systems would last for a long time without problems. It might be difficult or impossible for some houses to install qualifying septic systems because of soil conditions, while other houses would have an easy time. Regulation is a common solution, but in our example, it would not eliminate pollution of the lake because the function of the leaching field is to let partially treated water percolate into the soil. Some of the pollutants would still make their way into the lake, but at a far slower pace, which would likely cause no serious problems.
Another approach would be to determine how much pollution the lake can absorb and cap total pollution at this level. Each homeowner would be allowed to add their small share of pollution to the lake, perhaps the amount that would result from a decent septic system. The total effluent from all the homeowners would be capped, however so as to not exceed a level required to avoid long-term damage to the lake. The health of the lake would be preserved as long as the total pollutants do not exceed the maximum level. But with this system, as opposed to regulations, not all homes would need to be limited to the same amount of effluent. A market could be created so that homeowners with smaller houses and more efficient septic systems could eliminate their pollution altogether and sell their pollution allowance to other homeowners with larger homes and/or sites with poor soils.
A cap-and-trade system similar to this has been used successfully to maintain sustainable fisheries in Iceland, and to limit the emissions of sulphur dioxide (SO2) from power plants and other sources which cause acid rain. Cap-and-trade can achieve the same overall goal (limit pollution to a specific level) with less overall cost. In our lake story, some of the homeowners may have the resources and soil conditions to completely eliminate their effluent, while it would be very difficult or impossible for other homeowners to meet their allotment, because of bad soil or other site conditions. For such property owners, it might be less expensive to purchase pollution credits from other homeowners who have smaller homes or who have invested in more efficient systems. The cap and trade system can be more efficient and enable the collective to achieve its goals at a lower cost.
In our example, the market will set a price for adding effluent into the lake. This cost will be reflected in the price of the houses and in the maintenance of the septic systems needed to control effluents and keep the lake healthy. The cap-and-trade system is not without administrative costs. An institution or organization needs to keep track of effluents from the houses, to monitor the health of the lake, and to make adjustments to the cap as needed. Most cap-and-trade systems start with a high cap and gradually lower it over time. This gives industries time to find cost effective ways to reduce emissions.
A lake surrounded by houses is used as an example of why controls are needed to protect our common and shared resources. In the case of the lake, it might be collectively owned by the surrounding homeowners. Other shared resources such as our atmosphere and oceans are not privately owned, but are still shared resources. If the earth were the size of a basketball, the thickness of our atmosphere would be equal to the thickness of a sheet of paper. This fragile ecosystem regulates the temperature of the earth, filters out the most harmful ultraviolet light and performs many other critical functions necessary to support life. Human population is now over 7 billion and all of us have to work together to protect this common resource. If we don’t, our children and grandchildren will suffer from rising seas, more extreme weather events, drought and flooding.
In this polarized political environment, there is a strong voice for smaller government and fewer government regulations or intervention in the market, We would all like to see smaller government and fewer regulations, but we have to take the necessary actions to protect the common and shared resources that are so vital to the future. What I hope to show through this simple story of the lake is that some controls are needed, otherwise, the resources we all depend on will be seriously damanged or destroyed.
 Economists call these hidden and unaccounted costs “externalities”.