Lecture Seven: A Closer Look At Externalities
Sources: Various, but includes Public Finance (Ulbrich) and Public Finance and The American Economy (Bruce) and Welfare Economics and Externalities in an Open Ended Universe: A Modern Austrian Perspective (Roy E. Cordato).
What is an externality as it relates to markets? An externality is an economic cost or benefit that is the by-product of economic activity but that is allocated outside of the market system.
Example: A candy maker's factory is located right next to a doctor's office. The candy maker uses a machine that creates noise and vibration that penetrates the doctor's office - as a by-product of the production of candy. Because no market existed to allocate the cost, the allocation is external to the market system, so the candy maker is producing an externality.
All other costs of making the candy (buying the sugar, paying wages to labor, etc.) are allocated through markets and therefore these costs are born by the candy maker himself.
Another widely accepted definition (mainstream) by Baumol and Oates: "An externality is present whenever some individual's (say A's) utility or production relationships include real (that is nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A's welfare"
More common and broader definition: Externalities are costs or benefits that are felt by third parties as a by-product of productive (and consumption) activities.
Externalities can cause costs or benefits (usually called negative or positive externalities).
There are many categories of externalities:
Production Externality:
Consumption Externality:
Network Externalities:
If you decided to get a telephone, this provides a positive externality for those who want to call you from their telephone.
Externalities and the Efficiencies of Markets - The Standard Neo-Classical Theory
Private Costs + External Costs = Social Costs
Private Benefits + External Benefits = Social Benefits
Efficient Output of a Good: When Social Costs = Social Benefits
If a good does not produce any externalities, then the private costs and benefits = the social costs and benefits.
So the theory states --
Cost (or Negative) Externality: the market quantity of a good is greater than the "efficient" quantity.
Benefit (or Positive) Externality: the market quantity of a good is less than the "efficient" quantity.
Graph: Cost or Negative Externality in Production
Graph: Benefit or Positive Externality in Production
Graph: Cost or Negative Externality in Consumption
Graph: Benefit or Positive Externality in Consumption
Example: Education – supposed to create positive or benefit externalities because literate people are better to be around (communication, etc.). A kind of network externality in a way.
This is one argument for state-subsidized education. But if education creates positive externalities up to a point - then only provides private benefits, subsidizing it only benefits the individuals getting the education, not society at large.
Suppose that after 10 years of education everyone is sufficiently literate that getting more education would not increase anyone’s ability to communicate, etc. and therefore would not cause any more positive externalities. However, there are private benefits to two more years of education.
Taxpayers are subsidizing the individual - no externality.
Question: could it be argued that some education creates negative externalities? ? ? ?
Pecuniary Externalities
Pecuniary externalities only exist if we use the more broader definition of an externality because they take place within the market system (and therefore are seen as irrelevant to economists).
Another example of an irrelevant externality is a pecuniary externality: which occurs when an individual’s decision affects others through a change in market prices.
You buy a tube of toothpaste and this shifts the market demand slightly to the right, increasing the price. Everyone pays more for toothpaste.
Sounds like an externality. But there is an offsetting externality in this case. So although the individual’s consumption of the toothpaste increases the price slightly, this does not cause a net loss to the economy (assuming of course that the two externalities cross each other out, so to speak).
Consumers pay more, but toothpaste producers receive a higher price and earn a higher profit (higher producer’s surplus). In other words, the decision to consume more toothpaste just transfers consumer’s surplus into producer’s surplus. This affects the distribution of income in the economy but does not make it more or less efficient (using the standard definition).
Of course -- this is what people are complaining about right now -- that people who demand more health care because of life style choices are driving up prices of health care -- causing pecuniary externalities.
But isn't this true with anything that people buy? Should Bob argue that Jim should stop buying bread because it increases the price of bread?
Also -- there are also positive externalities (if you want to call them that) from more people consuming health care. As demand and prices increase, this shifts to the producer. This gives producers an incentive to create more and better products for the consumer in that market.
If you get a disease - you want a disease that a lot of people have -- because this induces a lot more resources into dealing with that disease. If there is only one person with the disease -- not many resources will be devoted to that disease.
Question: why are the benefits to the producers discounted, while the costs to consumers considered large and "unfair" by some?
Question: why is using resources on health care (as per demand from consumers) somehow bad vs. using resources on something else?
Wouldn't the whole issue go away if everyone were responsible for their own health care costs?
Graph - Pecuniary Externality
Externalities and Property Rights
Property right: legal rule of entitlement that grants the owner of a property the right to enjoy the benefits it provides, to command payment if the property is used for the benefit of others, to prevent trespass, and to sue for compensation in the event that he or she loses the benefits from the property (or the property is damaged by someone else).
Property rights allow the owner to appropriate the benefits of finding the more highly valued use. When property rights are missing or ambiguous, the market is not likely to perform this function.
The absence of property rights is a main reason externalities exist. If property rights can be established, costs and benefits can be internalized and no externalities exist. This then becomes a legal or technical problem.
Legal - the government doesn't allow the property right.
Technical - it is difficult or even impossible to establish a property right (in a "piece" of air that is blowing around, for example). But technology has come a long way at dealing with even this.
With property rights - or even in their absence - strict liability can go a long way towards solving externality issues.
Strict Liability: In law, strict liability is a standard for liability which may exist in either a criminal or civil context. A rule specifying strict liability makes a person legally responsible for the damage and loss caused by his or her acts and omissions regardless of culpability (including fault in criminal law terms, typically the presence of mens rea - which means "the act does not make a person guilty unless the mind is also guilty.")
-culpability is a measure of the degree to which an agent, such as a person, can be held morally or legally responsible.
For Example: The Tragedy of the Commons:
A common property resource is rival but not excludable. So each individual has an incentive to use as much of the resource as possible (otherwise someone else will use it). And they can’t establish a property right in its use until they use it. Basically it’s the prisoner’s dilemma again – all would benefit from conservation, but nobody has the incentive to conserve.
Examples: fishing, hunting, grazing cattle. Property rights in game animals, for example, are not established until the animal is dead - except on private game preserves.
The outcome: the destruction of the resource.
Basically this is a cost or negative externality. Since the good is rival, me using it increases your cost of using it, or even excludes you from using it if I consume it to the end. The more I fish, the higher the cost is for you to catch a fish.
The solution: Property rights. I can't use it unless it is my property or I pay the property owner. Then the costs and benefits are all born by the users of the property.
"It is important to remember this: Property rights generally are not something that government “grants” to people. They usually develop on their own." See examples from Native American tribes and others. (R. Stroup) This is the theory that Elinor Ostrom won her Noble Prize in Economics for (2009).
R - I - A - O
She looks at how the rules come about in the first place.....
http://www.env-econ.net/2009/10/ostroms-take-on-the-tragedy-of-the-commons-.html
Her basic message:
The Reciprocal Nature of Externalities
Example: Smoker vs. Nonsmoker:
How should the air in a room be used? The smoker wants to smoke and the nonsmoker doesn’t want any smoke in the room.
We typically see this only as a negative externality caused by the smoker, but what about the externality caused by the nonsmoker on the smoker if the smoker is not allowed to smoke?
So who should win?
Assumptions:
There are two people in a room, one is a smoker and one is a nonsmoker.
The smoker wants to smoke and has a willingness to pay of $5 to light up.
The nonsmoker wants the room smoke free and has a willingness to pay of $10 to keep it that way.
We assume that both people are fully informed about the dangers of tobacco smoke to their health and take these costs into account in their willingness to pay.
No one else is in the room.
1. Is it efficient for the scarce resource – the air in the room – to be used for smoking or kept smoke free?
The room should be kept smoke free. Because the nonsmoker’s willingness to pay for clean air is more than the smoker’s willingness to pay to light up. Keeping the air smoke-free is the highest valued use for the air.
2. Would this change if one person is assigned property rights to the air?
Coase Theorem: If transactions costs are low enough, the assignment of transferable property rights to a resource will create an efficient outcome.
Doesn’t matter who gets the property rights.
Remember, the smoker is willing to pay $5.00
The nonsmoker $10.
Obviously if the nonsmoker is given the property rights, the room will remain smoke free.
But what if the smoker is given the property rights – the nonsmoker will pay the smoker $6.00 not to smoke and it will remain smoke free.
But does the Coase Theorem always work?
3. What about transactions costs? If the smokers in a no-smoking restaurant have a higher willingness to pay to smoke than the non-smokers have for clean air, why don’t they offer a payment?
a. To the extent that the no-smoking policy gives property rights to the nonsmokers, they are probably not transferable - i.e., there's a No Smoking law.
b. Tradition and custom dictate that there are certain things we don’t bargain over.
c. High bargaining and transactions costs. Especially if there are a lot of people in the restaurant. How do the smoker’s decide how much to pay and how to divide the payment up? Even they do get together one of the nonsmokers might veto and demand a larger share of the payment.
ICE
Private Solutions for Controlling Externalities
Let's face it, basically externalities boil down to conflicts of values between individuals (at least with respect to negative externalities). I want the lake to swim in and you want the lake to pollute in. I want a smoke free room and you want to smoke. In many cases (I would say most), especially when property rights are clearly defined, the least cost way of dealing with externalities is to let the individuals work it out on their own.
1. Coase Theorem: if property rights are clearly defined, then the problem takes care of itself. However, as we see - there are problems.
Voluntary agreements or contracts: Bee Keeper and apple grower make a contract, train and field example.
2. Persuasion
3. Integration or merge: Bee Keeper and the apple orchard example, train and field example.
4. Charities (for positive externalities): voluntary subsidies to places that provide positive externalities for example. Although we never hear people complaining about positive externalities!!
Government Policies for Controlling Externalities
Policies to control externalities can be grouped into two types:
Correction: adjusts activities with externalities by creating a corrective penalty or reward.
For a cost externality the corrective policy might subject them to a penalty unless they reduce it. Could be a fine or punishment for exceeding limits, or a tax on the activity.
For a benefit externality the corrective policy might be a subsidy – or a penalty for not producing enough.
Internalization: adjusts activities with externalities by changing the institutional arrangements that led to the externalities in the first place.
This is the more the government getting out of the way instead of getting in the way. Two examples:
1. Allow Mergers: Let’s say you have a group of firms that hire similar employees. If one firm trains its employees, they could work for any firm. So firms try to free ride off the training of other firms (firms that train the employees create a positive externality for other firms).
The answer: merge. But firms don’t need the government to tell them about the efficiencies of mergers. And if the firms don't merge, this would tell us the free riding isn't that big of a deal.
So what the government can do is remove obstacles for mergers. Does this say that antitrust laws possibly cause externalities to persist?
2. Enforce Property Rights: Another internalization policy is for the government to enforce property rights – make a common good a private good (sell off some of its common property).
3. Enforce Strict Liability: This always reduces the incentive to create the externality in the first place. Sometimes economists call this negative incentive (I don't have the incentive to reduce the risk of an oil spill because the oil spill would happen on public land, for example).
Command and Control Policies
Most government policies toward externalities are command and control policies; consisting of regulations that command polluters to do certain things, such as purchase pollution-control equipment, and to control their polluting activities.
For example: the amounts and types of waste products (effluents) that a firm can discharge into the environment are controlled and must be less than specified limits. Some things, such as hazardous waste cannot be dumped at all.
1. Quantity Standards are often set.
Problem: What is the "right" quantity?
2. Technology Standards specify the equipment and processes that firms and individuals must use.
The Clean Air Act sets quantity standards on different types of air pollutants the firms can emit and also on emissions standards for individuals.
Problems:
How does the government know which equipment and processes are best? Forcing one will stifle innovation of better equipment and process. Also,
setting standards is one thing; enforcing them is another! Very costly.
3. Variable and Tradable Permits
With command and control policies, the limit is fixed regardless of the cost the firm must incur to comply with the standard. So the standards are in conflict with the interest of the firm. All firms, regardless of their costs of abatement, face the same limits.
This makes the cost of the pollution abatement higher than it needs to be.
The Clean Air Act of 1990 introduced what is now called emissions trading –which created a market in transferable discharge permits for sulfur dioxide.
The government issues transferable discharge permits equal to the total level of emissions that it wishes to allow and then lets firms buy the permits they need in order to emit. The firms with higher cost of abating pollution will bid the most for the permits, whereas the firms with lower abatement costs will choose to sell their permits and reduce their emissions instead.
Pros to those who like it - Why efficiency enhancing: If one firm has higher abatement costs than another, they will purchase the permits and the firms with lower abatement costs will do more abatement.
But how does the government determine the initial allocation of permits?
According to the Coase Theorem, it doesn’t matter. Trading will lead to the efficient allocation.
Another advantage: the policy rewards plants who invest in abatement equipment or find other ways of reducing their emissions below the existing standard.
Problem: How many permits should be issued?
Some say that this still allows pollution - which is bad.
4. Effluent Charges and Corrective Taxes: an effluent charge or fee is a dollar price charged to plants per unit of effluent (smoke or dirty water) they discharge into the air or watershed.
GRAPH: The Effect of an Effluent Fee
At the efficient quantity of effluent, the marginal external cost (MEC) is equal to MWTP to dump by the firms. Firms would dump Qm. With the charge, firms dump Qc, and the most efficient would be Q*.
Closely related to effluent charges or fees are corrective taxes or subsidies – these are imposed on a good or service subject to a production or consumption cost externality, and a corrective subsidy is imposed on a good subject to a production or consumption benefit externality.
Example of a cost externality in consumption: gasoline, which causes air pollution when used by automobiles, or alcohol and driving.
GRAPH: A Corrective Excise Tax on Gasoline
Problem: how much should the taxes or subsidies be?
5. Different ways of Assigning Property Rights: To get rid of the tragedy of the commons. So to prevent over-fishing, assign property rights to so many fish, and that’s it.
a. When there is an overall limit for the season, not on individual fishermen, this is called the “derby system” because it allots property rights to those fishermen who can catch the fish first – creating a race.
The problem with this is that this causes a rush to catch fish early in the season – flooding the market with fish and driving down prices! Then when the derby ends, consumers are out of fish!
It also encourages firms to invest in bigger and faster fishing boats – this adds to the cost of fishing and the cost of fish. And once the capital investment is made, the fishermen need the derby system to continue to make it worthwhile, so they lobby for this (also a waste).
Individual transferable quota: the right to catch a given fraction of the overall quota each year. This is known as “privatizing the fishery”.
Low cost fishermen can purchase rights from higher cost fishermen, making it even more efficient. And we don’t have the rush.
Each fishing firm owns a fraction of the fish – giving them an incentive to conserve the stock in order to achieve a sustainable yield.
Problems: How many fish should be caught each year? Can determine a "sustainable" yield with fish - but what about with say, pollution?
How should the individual rights be assigned? Given to the fishermen in the industry now? Sold to the highest bidder?
Does it matter? According to the Coase theorem, it doesn’t matter for an efficient outcome.
However --
As we have discussed, the whole "welfare" standard of efficiency becomes useless except in some theoretical sense.
If we can't measure costs and benefits -- the concept of "social benefit or cost" becomes meaningless. All costs and benefits are inherently private.
So all of this analysis can't be translated into reality in any meaningful way. Therefore, what "solutions" take place come about due to politics and not what might be best (however one defines this). Much of this just becomes pretty arbitrary! And whether you think it is good or bad is based on your own personal ethics. But remember, there is always a cost - always!
ICE