Externalities and the Environment

What is an Externality? When a person/firm does something that affects the interests of another person or firm without affecting prices. Examples: Traffic/telephone/internet congestion Over grazing New fences Building a road

Does not Affect Prices? This means: You cannot use markets to give people incentives to do the right thing. Called: A Missing Market Or Market Failure

Kinds of Externality Beneficial Consumption 2-person Stock Affecting Utility Public Harmful Production Many person Flow Affecting Production Private

Why this presents a problem An externality implies: Social Cost = Individual Cost Social Benefit = Individual Benefit The incentives for the individual are not what society wants them to do. As a result: too much of socially costly goods are produced too little of socially beneficial goods are produced.

An Example : One Polluting Supplier of Coffee Demand for Cups of Coffee = Marginal Social Value for Coffee Price Quantity of Coffee

Private Equilibrium determined by private costs and demand Price Marginal Private Cost Marginal Social Value Quantity of Coffee

Suppose the social costs of coffee production were higher than the private costs (a negative externality) Marginal Social Cost Price Marginal Private Cost Marg Social Value Quantity of Coffee

Consequences (1) Too much coffee is produced. (2) The price so coffee is too low and does not reflect its true costs of production. (3) Who gains here? (4) What are the values of the costs imposed on society?

Consumers Value For Unregulated MSC Price MPC MSV/Demand Quantity of Coffee

Consumers Value at social optimum MSC Price MPC MSV/Demand Quantity of Coffee

Consumers Gain MSC Price MPC MSV/Demand Quantity of Coffee

Society s Net Loss: Consumers are not paying the true Social Cost of Production MSC Price MPC MSV/Demand Quantity of Coffee

Some Solutions to the Pollution/Externality Problem Private Solutions (No Government) 1. Internalize the Externality: Somehow get the social cost to equal the private cost by enlarging the organization. e.g. Make the coffee store own a street cleaning company. 2. Assign Property Rights: Allow neighbours to sue the store for violating their rights to clean streets. (See Coase discussion below) 3. Common Law: Allow injuries to be compensated without property rights being invoked.

Public Solutions: Fines or Taxes? There are 2 alternatives: 1. Tax polluters to raise their private costs to the social cost. Pigouvian tax. Question: What kind of tax does this? 2. Subsidize abatement technology so the social costs of production are lowered.

Supply Curve = Marginal Private Cost Price MPC Quantity of Coffee

The Problem: Pollution => Social Cost > Private Cost MSC Price MPC Quantity of Coffee

Individuals Choices Compare Private Cost with Their Individual Value Price How much individuals choose to consume. MPC Marginal Social Value Quantity of Coffee

But it is Optimal for Society to have less produced MSC Price MPC Marginal Social Value Quantity of Coffee

Pigou s Solution: Taxes Increase the Price at which the Good is Supplied MPC+tax Price MPC Tax Quantity of Coffee

This increases the Price and Reduces the Quantity Consumed MPC+tax Price MPC Tax Marginal Social Value Quantity of Coffee

If you choose the tax just right then we get to the same place: And the government raises revenue. MSC MPC+tax Price MPC Marginal Social Value Quantity of Coffee

An Alternative Route the Producers like Provide subsidies to reduce polluters costs of being clean.

Subsidize Abatement: The Original Position how much abatement gets provided Costs/Benefits Marginal abatement cost Marginal Private Damage Cost Quantity of Abatement

The Problem = Costs of Damage for Society > Individual polluters Cost =>Not enough abatement Costs/Benefits Marginal Social Damage Cost Marginal abatement cos Marginal Private Damage Cost Quantity of Abatement

Subsidize Abatement: Reduces Abatement cost Costs/Benefits Marginal abatement cost Subsidy Quantity of Abatement

Subsidizing Abatement => More Abatement is provided Marginal abatement cost Subsidized Cost Marginal Private Damage Cost Quantity of Abatement

If you get the subsidy just right you can get to the social optimum. Marginal abatement cost MSDC Marginal Private Damage Cost Quantity of Abatement

This is has distributional and welfare effects Abatement subsidies: Benefit producers and do not raise the prices of the polluting products. They raise government spending and increase general taxes. As a consequence consumers do not bear the full social cost of the product they are consuming everyone bears it. Too much is consumed and produced. This is not the case with Pigouvian taxes.

Other Governmental Solutions Command and Control Just tell the producer how much they are allowed to produce (quota). Performance based regulation how much can be emitted. Input regulation what kind of production processes can be used

Government can impose a market 1998 BP committed to reduce greenhouse gas emissions 10% below 1990 levels by 2010.

Internal Markets for Coordination : BP 1998 BP committed to reduce greenhouse gas emissions 10% below 1990 levels by 2010. Usual process would be: 1. Senior managers set targets for divisions. 2. Complaints, bargaining and negotiation by divisions (some would find targets difficult and very expensive to meet others would find them very easy). 3. Slow inefficient and uncoordinated reductions or maybe none at all.

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol).

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol). New process: 1. Senior managers set targets for divisions.

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol). New process: 1. Senior managers set targets for divisions. 2. Target implemented by allocating that division permits to emit targeted amount of GG. 3. Set up an internal electronic trading system. 4. Business managers could then either 1. Meet their target. 2. Reduce their emissions by less and buy extra credits.

BP : Key Outcomes BP met its goal 9 years early.

BP : Key Outcomes BP met its goal 9 years early. The decisions across the organization were consistent and coordinated: In parts of the organization where reduced GG was cheap <$40 they make big reductions and sell permits. In parts of the organization where reduced GG was expensive >$40 they buy permits.

Pro s and Con s of Pigou vs Command Pros Efficiency (static) across different polluters. Cons Difficult to get right Incentives to reduce pollution in the future (dynamic efficiency). May not need uniform treatment. Raises revenue and can eliminate other (worse) taxes. If already monopoly, then pollution under provided

Coasian Decentralized Solution Idea allocate property rights and let the polluter and the polluted negotiate a solution. Bargaining between the polluter and the polluted Polluter Set of Feasible Agreements Polluted

Coasian Decentralized Solution If the polluter has the right not to be polluted, then if no bargain is reached the polluted can take the polluter to court and fine them for a violation Polluter Outcome imposed by law Polluted

Coasian Decentralized Solution Negotiated solution should be better than this for both parties. Polluter Negotiated Outcome Polluted

Coasian Decentralized Solution If the polluter has a right to pollute (eg be noisy) and then the law will impose a settlement that is good for the polluter. Polluter Legal Outcome Polluted

Coasian Decentralized Solution The negotiated outcome is now more favourable to the polluter. Polluter Negotiated Outcome Polluted

Coasian Decentralized Solution Summary: Coasian negotiation depends on who gets the rights but will be efficient under perfect information. Polluter Negotiated Outcomes Polluted

Problems of the Coasian Solution It requires: (1) Very clear property rights. (2) No costs of transactions. (3) Perfect information

Is Bargaining Always Efficient? A simple demonstration of impossibility.

A Simple Bargaining Problem There is a project under consideration. A seller can build the project, a buyer can use it. The project gets built if the seller and buyer can agree on terms.

A Simple Bargaining Problem There is a project under consideration. A seller can build the project, a buyer can use it. The project gets built if the seller and buyer can agree on terms. The project is either easy or hard for the seller. Easy C = 35 Hard C = 60

Inefficient bargaining 1 For the buyer, the project has either low or high value.

Inefficient bargaining 1 For the buyer, the project has either low or high value. Low V = 40 High V = 65 Again probability ½ on each. V and C are statistically independent. And, critically, they are not observable to the other player.

Inefficient bargaining 2 Buyer or seller cannot be forced to participate. So, for example, when the project is hard, the seller must expect to receive at least 35 on average. (It could be that there is some lottery aspect, so that sometimes he does, and sometimes not.)

Inefficient bargaining Potential Gains to Trade: Buyer value Low High 40 65 Each cell occurs ¼ of time, so expected gains are ¼(5+0+5+30) = 10 Seller cost Easy 35 Hard 60 5 0 30 5

Theorem There is no bargaining procedure under which the project gets built if and only if it is efficient to do so.

Why? Some intuition. Imagine that we agree that we will both say our type. Then we will build the project when it makes sense, and set prices to split the difference.

Why? Prices First, let s try to build Buyer value some intuition. Imagine Low High that we agree that we will both say our type, and 40 65 Easy 37.50 50 then we will build the project when it makes Seller 35 sense, and set prices to cost split the difference. Hard 60 0 62.50

Difficulty If the low cost seller says he is low cost, Then the project always gets built, ½ the time at a profit of 2.50, and half the time at profit of 15, for an average of 8.75.

Difficulty But, if the low cost seller pretends his costs are high, then the project gets built ½ the time at a profit for the seller of 62.50 35.00 = 27.50. Expected profit from lying is ½(27.50)=13.75! The low cost seller will not tell the truth.

So maybe we could choose smarter prices? Or some different mechanism? No none work. As long as values are private information, there is nowhere to go here. There is no mechanism that gets players to tell the truth and builds the project whenever it should be.

Fundamental Issue When the seller s true cost is 60, He will end up building the project ½ the time, and getting paid at least 60 when it is built (otherwise, he is better not to participate when C = 60).

Fundamental Issue When the seller s true cost is 60. He will end up building the project ½ the time, and getting paid at least 60 when it is built (otherwise, he is better not to participate when C = 60). So, with low costs, he can always lie and earn ½(60-35)=12.5. Thus, whatever the real mechanism is, it must give the seller expected profits of at least 12.5 when his type is C = 35.

Fundamental Issue Whatever the real mechanism is, it must give the seller expected profits of at least 12.5 when his type is C = 35. So, looking at the game before types are known, the seller has to expect to earn at least 12.5 at least ½ the time (when his costs are low). Seller s expected profit is thus at least 6.25, independent of the mechanism.

Inefficient bargaining The story for the buyer is the same. He can always pretend to have low value. Same calculation as we just did then shows that he also has to have expected profit at least 6.25, independent of the mechanism. Problem is that right at the beginning, we showed that the expected gains from trade were only 10. There just isn t enough to go

Inefficient bargaining Quite generally: It is impossible for bargaining or negotiation to always arrive at the efficient frontier. The conditions of the Coase theorem are going to fail often. (Recall this is the idea that individual negotiation must drive us to efficiency. Thus maybe there is a role for organization?)

It is easy to get some of the gains to Trade. For example, build only if seller says he has low costs, and buyer says he has high, and do so at price 50. Then, it pays each type to tell the truth.