ECON 262
Notes on Environmental Economics, Externalities, Tragedy of the Commons, etc.
Economists tend to approach environmental issues the same way they approach all social issues. The same assumption (self interest) about human behavior is made and the analysis follows from that assumption.
Economists also tend to emphasize cooperative solutions over one's that entail conflict (being social scientists). Remember, however, that competition is seen as a cooperative activity to economists -- think about how many people cooperate in order to compete! Conflict usually comes about via politics. Look at the conflict that takes place in Washington, D.C. almost every day.
ALWAYS REMEMBER - perfection is Unattainable (whatever that may be). We can't judge any policy, law, institution, economic system, etc. against perfection - we must judge it against a viable alternative!!
And keep these principles in mind:
from an Environmentalist Economist - Richard Stroup
1. Scarcity, even in a nation as wealthy as the United States, is always with us, so choices must be made.
2. People share many values, but each person has a narrow focus and somewhat different purpose; each person wants to emphasize different goals.
3. Although scarcity leads to competition, some forms of competition lead to constructive action that reduces scarcity, while other forms are destructive.
4. Incentives matter!! If you set up the rules such that people don't agree with them (they go against their interests) - it is guaranteed that there will be unintended (almost always negative) outcomes - often the opposite of what was intended.
5. Both parties gain from trade.
6. In a competitive market, market prices conserve resources.
7. Information is a valuable, but costly, resource.
8. Advanced technologies typically help the environment because they decrease resource waste and increase resource productivity.
9. As people's incomes increase, their willingness to pay for protecting the environment increases.
10. The most common error in economics, and perhaps also in ecology, is to ignore the secondary effects and long-term consequences of an action. Remember – an economic system, like an ecological system, is strongly interconnected – and complex!!
Externalities - When costs or benefits are secondary - problems!!
Externality: the uncompensated impact of one person's actions on the well-being of a bystander. You do something to benefit yourself but in the process cause a cost or benefit for someone else. So the cost or benefit is "external" to you.
Positive:
Negative:
Examples:
Economists usually talk about: Internalizing the Externality - when the party causing the externality must take the cost into account (pay) if it is a negative externality or when the party causing the externality is compensated for creating it (gets paid) if it is a positive externality.
This will (theoretically) lead to a decrease in negative externalities and an increase in positive ones.
The idea is that the "private" costs or benefits do not equal the "social" (or total) costs or benefits. Of course in reality there are no "social" costs and benefits -- none of this can be measured!!!!
But here is the theory:
Social Cost = Private cost + External cost or Social Benefit = Private benefit + External benefit
The mainstream theory then is: an "efficient" outcome is where marginal social costs = marginal social benefits. If only the private costs or benefits are included, then the "efficient" amount of production and trade will not take place.
Examples of different kinds of externalities - (Graphs and Examples)
Negative Externalities in Production:
Positive Externalities in Production:
Negative Externalities in Consumption:
Positive Externalities in Consumption:
Of course - sometimes we can't determine who is causing the externality - or we don't discover the externality until after those who created it are gone.
So what are ways to internalize?
Private Solutions Toward Externalities:
1. Assign property rights and allow voluntary agreements or contracts: if property rights exist and if private parties can bargain without cost (or with low enough costs), they can solve the problem of externalities on their own. Does not matter how the property rights are initially distributed. Depends upon the transaction costs (the opportunity costs of conducting a transaction) of bargaining. (Ronald Coase)
The fly-fishing/farmers example. The farmer's use of the water created a negative externality for the fishermen - so they bargained. The fishermen paid the farmers not to farm.
But externalities work both ways: Take for example smoking. Smokers might create negative externalities for non-smokers - but if smokers do not smoke to please the non-smokers, then they have a negative externality put on them.
Precedents (norms) are important in determining respective property rights.
Then, of course, once property rights are assigned - invading another's property or person can be taken care of under the criminal legal system. For example, fraud or assault. Or Strict Liability!
Problem: Property rights not being clearly defined, or difficult or impossible to determine who is damaging another's property.
More on Property Rights Later!
2. Moral codes/social sanctions:
Problem: not everyone abides by moral codes.
3. Persuasion:
Problem: everyone can't be persuaded and/or negotiation costs can be high
4. Integration:
Problem: negotiation costs can be high or the cost of integration itself is too high
5. Charities (positive externalities):
Problem: not everyone wants to give to charities
Public (Government) Policies Toward Externalities: (Problem with all of these - involves the use of force)
1. Regulation:
a. ban production processes
Problem: don't know if the costs outweigh the benefits (Knowledge Problem)
b. specify minimum air or water quality levels
Problem: what level is best? - and why try to go below it with better technology - kills incentives to come up with better ways of doing things (Knowledge Problem)
c. the government specifies what kind of technology is used
Problem: stifles innovation - again, kills incentives (Knowledge Problem)
2. Taxes and Subsidies:
a. tax those who pollute
Problem: hard to know who to tax sometimes - and certainly how much? (Knowledge Problem)
b. subsidize those who create positive externalities
Problem: hard to know who to subsidize - and certainly how much? (Knowledge Problem)
3. Tradable Pollution Permits (Cap and Trade):
NOTE: Another problem with all of these government solutions is political pressure from interest groups to achieve specific outcomes. These groups have political power – but do not bear the costs of what the government does. So the policy takes place – not because of sound theory and evidence – but because of special interest group pressure.
Because of this and information problems - not knowing the lowest cost technology or the “costs” or “benefits” of individuals that derive from different options –
Economists in general will emphasize property rights as a way of internalizing externalities. Let's look deeper...
But first let’s do an ICE
Property Rights, Free Riding, and the Tragedy of the Commons
Property Right: The owner has the right to dispense with the property in a manner he or she sees fit, whether to use or not use, exclude others from using, or to transfer ownership. Property rights and incentives are very much related. With ownership rights -- if I can increase the value of my property - I can reap the rewards from doing so.
From Stroup: There are three dimensions, or three characteristics that effective property rights share.
1.) Rights must be defined .
2.) Rights must be defendable.
3.) Rights must be freely divestible (meaning that the owner is free to sell - or rent or lease - the resource to any willing buyer).
Common Resource: goods that are not owned by any one person - no one is excluded from its use.
Free Rider Problem: an individual reaps the benefits from free-riding, but the costs are spread among the whole group. So individuals have an incentive to free ride.
A person receives the benefit of a good but avoids paying for it - with common property, people have an incentive to "free ride" off of others - throwing trash on the beach in the hopes (or assumption) that someone else will pick it up. But if everyone is free riding...... what happens to the beach?
Tragedy of the Commons: common resources get used more than is desirable - even to the point of destruction. Each person wants to "free ride" off of others - and/or they want to use the property before someone else can.
Example from the Issues book: Codfish off the New England and Canadian coasts. Problem - the fish had to be hauled from the sea before rights to it could be established. The result was over-fishing - each fisher could benefit by catching fish but the cost (fewer fish in the future) was spread among all fishermen. The catch dropped dramatically over a 30 year period - more than 75% (and the fish got smaller). As a result -- the cod fishing in that area is virtually gone.
Possible solution - Catch Share System:
Total allowable catch (TAC):
Individual transferable quotas (ITQ):
Main Economic Solution to the Tragedy of the Commons: Property Rights
"It is important to remember this: Property rights generally are not something that government “grants” to people. They usually develop on their own." There are many examples.
History is full of examples of voluntary associations – all designed to bring order to competing claims before the formal claims process applied to the land. These groups often had (and remember, there’s no government involved here):
· by-laws
· a constitution
· a management pact
· a leadership selection process
· a procedure for handling disputes
Often too – cultural norms simply emerged out of the benefits that came from them that included property rights like institutions. There were no formal, written codes – but behavior and social sanctions upheld the property rights.
Examples of groups from the American frontier:
· Land clubs
· Cattlemen’s associations
· Wagon trains
· Mining camps
Cattlemen and livestock associations throughout the West sought to define and enforce private property. Some of the first dude ranches in Colorado for example – Estes Park being a good example – were started by cowboys who saw the value in keeping the land as it was – and that’s what they did. When the government moved into Estes Park and tore down the old structures – and replaced much of the land with parking lots, etc. – well, some of the old cowboys would argue they were much better conservationists than the government forest service!
Example from Native Americans:
Montagnais Indians and beavers –
Also, different colors on arrow tips to establish property rights in buffalos.
Again – how the property rights come about is very important –
Each local situation has unique characteristics. Therefore, rules established by those involved are best for their situation. They are established with local knowledge – and local incentives. Remember – these can be complex problems that require complex solutions. Not one-size-fits all top-down government solutions.
This is the theory that Elinor Ostrom won her Noble Prize in Economics for (2009). http://www.env-econ.net/2009/10/ostroms-take-on-the-tragedy-of-the-commons-.html
How/Why Do Property Rights Improve Environmental Quality – Some Theories
1. Internalization of Externalities
A famous article by economist Herald Demsetz (1967) set the stage.
He argues that one of the fundamental functions of property rights “is that of guiding incentives to achieve a greater internalization of externalities.” He argues that property rights emerge when the costs of internalizing externalities are outweighed by the gains of internalization. In this manner, property rights can help internalize the costs of pollution and promote environmental quality.
In other words – if you own the property that you pollute – you bear the cost (or at least most of it). This gives you an incentive not to pollute!!
Or, well defined and enforced property rights hold people accountable and create incentives to maintain and allocate resources efficiently, because owners bear any losses from the mismanagement of their resources. In this manner, property rights affect the utilization and allocation of natural resources.
The absence or uncertainty of property rights leads to more rapid land and natural resource use.
For example, poorly defined property rights exacerbate the process of deforestation, representing an emphasis on the short-term use of a natural resource.
2. Entrepreneurship and technological innovation
Secure property rights enable firms and entrepreneurs to benefit from innovation. Innovation helps to protect the environment by introducing new technologies that reduce pollution and new production methods that require the use of fewer raw materials.
3. Makes environmental quality affordable
The literature is full of examples of the relationship between property rights and economic growth. At first glance – economic growth would seem to have bad environmental consequences (more on this later). However, with economic growth we get higher incomes. Environmental quality seems to be a normal good – people demand more of it when their incomes go up. Again – more on this later.
Let’s look at one recent study (empirical evidence):
A study by Carie Kerekes (2011) found that where property rights can be well defined and enforced, as with property rights pertaining to land and water, increases in the security of property rights lead to improvements in environmental quality.
For example, she found that as property rights become more secure, deforestation decreases and access to safe water and sanitation facilities improves.
When property rights cannot be (or just are not) clearly defined, such as property rights over the air, increases in the overall security of property rights may erode environmental quality. For example, she found that more secure property rights are positively related to several indicators of air pollution.
What was her theory?
She says that property rights have both direct and indirect effects on environmental quality:
Direct Effects: as property rights become more secure, individuals have incentives to maintain, conserve, and efficiently allocate resources.
Indirect Effects: as property rights become more secure, there are increases in production, exchange, and economic development. This process has an indirect impact on environmental quality: as more rapid industrialization occurs, firms may increase air pollution.
So the direct effect is positive (on environmental quality) while the indirect effect is negative.
The net result will depend on the magnitudes of these direct and indirect effects.
Also - it is hard to define and enforce property rights on air and in some cases, water.
Therefore, although pollution is declining in developed countries, air and water quality are still difficult to ensure due to problems arising from the assignment of liability for pollution.
Population Theory: When it is not easy to identify polluters, the rights to clean air and water are not vested in particular individuals and the costs of pollution can easily be passed on to other individuals.
Large numbers of people make it difficult to define and enforce property rights and to assign liability for pollution.
As the the number of parties affected by pollution increases, the damage each individual faces is likely to be small. Free-rider problems occur, with individuals having little incentive to take action against the polluter.
Likewise, large numbers of polluters make it difficult to find the source of pollution and to assign liability.
Therefore --- an increase in the number of individuals increases the cost of internalizing externalities! (see also Harold Demstez, 1967).
Economic Growth and the Environment - Are They Compatible?
Let's now return to principle #9 above and also the Indirect Effects of property rights on the environment: As people's incomes increase, their willingness to pay for protecting the environment increases.
So there does appear to be a secondary indirect effect -- production does increase, which increases, say air pollution. But as productivity increases, eventually people reach a level of income where they start "demanding" a better quality environment.
Some economists have found that pollution often appears first to worsen and later to improve as countries’ incomes grow.
Because of its resemblance to the pattern of inequality and income described by Simon Kuznets, this pattern of pollution and per capita income has been labeled an ‘environmental Kuznets curve’.
The theory: at relatively low levels of income the use of natural resources and/or the emission of wastes increase with income. Beyond some turning point, the use of the natural resources and/or the emission of wastes decline with income.
GRAPH:
Why? Reasons for this inverted U-shaped relationship are hypothesized to include income-driven changes in:
(1) the composition of production and/or consumption - people can afford to change both how they produce goods/services and they can afford to choose goods/services that are more compatible with a better environment.
(2) the preference for environmental quality - environmental quality is seen as a "normal good." People demand more of it as their income increases.
(3) institutions that are needed to internalize externalities - these become "affordable" at higher incomes. Could be government institutions or private institutions - with high transactions costs in trade (the fly fishing example), people can afford to pay them with higher incomes.
(4) increasing returns to scale associated with pollution abatement - with higher incomes, more people demand environmentally friendly goods - so firms are able to produce them cheaper due to increasing returns to scale (economies of scale).
The Evidence?
Mixed.
Some economists found that while many pollutants exhibit this pattern, peak pollution levels occur at different income levels for different pollutants, countries and time periods.
Most famous studies are from those that really introduced the idea - Grossman and Krueger (1995) used a simple empirical approach. They looked to see if there is a correlation in the data between air and water quality in cities worldwide and income per capita and other city and country characteristics. They found that many of the plots of data appear inverse-U-shaped, first rising and then falling. The peaks of these predicted pollution-income paths vary across pollutants, but in most cases they come before a country reaches a per capita income of $8,000 in 1985 dollars (Grossman and Kruger, 1995, p. 353).
Note: $8,000 in 1985 would be about $17,626 now.
Many other studies have followed. Some generalizations across these studies have emerged.
a. Roughly speaking, pollution involving local externalities begins improving at the lowest income levels. Fecal coli form in water and indoor household air pollution are examples. For some of these local externalities, pollution appears to decrease steadily with economic growth, and we observe no turning point at all. This is not a rejection of the EKC; pollution must have increased at some point in order to decline with income eventually, and there simply are no data from the earlier period.
b. By contrast, pollutants involving very dispersed externalities tend to have their turning points at the highest incomes, or even no turning points at all, as pollution appears to increase steadily with income. Carbon emissions provide one such example. This, too, is not necessarily a rejection of the EKC; the turning points for these pollutants may come at levels of income per capita higher than in today’s wealthiest economies.
These could both be predicted theoretically. The closer one is to the cost of his own actions, the more likely he will do something about that cost. Living with open sewer at your front door - well, brings action sooner. Driving a car and not recognizing the externality at the moment - action is put off.
Criticisms of the Theory:
1. Methods used in the studies have been criticized. Measuring the pollution, for example. And other statistical problems.
2. More developed countries could be shipping their pollution to the less developed countries - this skews the results. Like manufacturing of clothing and furniture, to poorer nations that are still in the process of industrial development. Thus, this progression of environmental clean-up occurring in conjunction with economic growth cannot be replicated indefinitely, because there will be nowhere to export waste and pollution intensive processes.
3. Industrial societies will continually produce new pollutants as the old ones are controlled - so it is a never-ending battle.
DO ICE