Dealing With Negative Externalities -An Experiment
The country of Emissia is a small island nation with an economy that
produces only one good -- small, beautifully hand-crafted lawn ornaments.
The natives of Emissia are a proud people and they love these ornaments
that have become emblems of their homeland. A substantial percentage of
Emissians own and display a lawn ornament in their front yards.
However, there is a down side to these lawn ornaments. The coal-fired
furnaces used in the factories that make the ornaments produce a fetid grey
smoke that leaves a residue of grime all over the island. Because of this
pollution, trades that benefit both the buyer and seller can cause harm to
third parties. Because of these side-effects, unrestricted trade in the market
for lawn ornaments leads to an inefficient outcome.
This experiment is intended to demonstrate how public policies can be
designed by government to address the problems of negative externalities.
based on an experiment developed by Theodore Bergstrom and John Miller, Experiments
With Economic Principles (New York: McGraw-HillCompanies, Inc.: 1997).
Externalities
• A negative externality exists when all of the social costs associated with the
production and consumption of a good or service are not captured by the
private market. When a negative externality exists the private market
produces a more-than socially optimal level of output. There is too much
production. Government usually attempts to decrease the level of output
by placing regulations or taxes on the production or consumption of the
good or service. An example of a good/service with negative externalities is
motor vehicles (pollution).
• A positive externality exists when all of the social benefits associated with the
production and consumption of a good or service are not captured by the
private market. When a positive externality exists the private market produces
a less-than socially optimal level of output. There is too little production.
Government usually attempts to increase the level of output by subsidizing
the production of the good or service or by providing the good or service
itself. An example of a good/service with positive externalities is childhood
immunizations (public health benefits).
Preliminaries
• Each student will receive a Personal Information Sheet [PIS] that indicates
whether he or she is a buyer or seller of lawn ornaments. The Personal
Information Sheet will also indicate the Buyer Value or Seller Cost for each
student, whichever is appropriate.
• We will conduct three sessions of this experiment. Before Session 1, the
instructor will tell the participants in the experimental market the amount of
damage that is imposed on everyone by pollution from producing each lawn
ornament. If, for example, the instructor announces that producing one lawn
ornament causes $1 damage to everyone, and if 15 lawn ornaments are sold
in the trading session, then everyone in the experiment, including those who
make no trades, will realize a “pollution cost” of $15.
• In Session 1, there is no government interference in the market for lawn
ornaments.
• In Session 2, the government imposes a “pollution tax” on the sellers of lawn
ornaments.
• In Session 3, a seller is allowed to sell a lawn ornament only if he or she has
a “pollution permit”.
Session 1
• Buyers and sellers who agree on a price can sign a
contract and bring it to the instructor. If a supplier with
Seller Cost $C sells a lawn ornament to a demander
with Buyer Value $V for price $P, the seller will earn a
profit of $(P-C) and the demander will earn a profit of
$(V-P) from the transaction. However, in this
experiment, everyone in Emissia, whether they buy,
sell, or do not transact at all, will have to pay the
pollution cost. If 15 lawn ornaments are sold, and if
each lawn ornament that is produced causes $1 worth
of pollution damage to every citizen, then the profits of
each participant in the experiment will be reduced by by
$15.
Session 2
• In this session, the government imposes the “pollution tax” on
the production of each lawn ornament. The revenue collected
from the tax will be redistributed in equal shares to all citizens.
In this session, a supplier with a Seller Cost $C sells an
ornament to a demander with a Buyer Value $V for price $P, and
if the tax per ornament is $T, then the seller’s after-tax profit from
the transaction is $(P-C-T) and the demander’s profit is ($V-P).
In addition to any profits they may make from buying and selling
lawn ornaments, every Emissian will receive an equal share of
the government’s tax revenue, and every Emissian will suffer a
loss of income equal to the amount of the pollution damage
imposed on each person by the production of lawn ornaments.
Session 3
• In this session, a supplier is allowed to sell a lawn ornament only if she or he
has a pollution permit. At the beginning of the session, some participants will
receive marketable pollution permits along with their PIS. The original owner
of the permit can resell this permit to anyone else, but a pollution permit can
only be sold once. When a lawn ornament supplier buys a pollution permit,
the buyer and the seller of the permit must write their ID numbers and the
sales price on the permit. The seller of the pollution permit receives a profit
equal to the price at which the permit was sold. Having acquired a pollution
permit, a lawn ornament supplier is allowed to sell a lawn ornament to a
demander. When a supplier has completed the sale of a lawn ornament, she
(he) and the buyer should fill out a sales contract and bring it to the instructor,
along with the pollution permit that entitles the seller to sell an ornament.
• The lawn ornament seller’s total profit from her (his) production activities is the
price she (he) receives for the ornament, minus her (his) Seller Cost, minus
the price she (he) pays for the pollution permit. The demander’s total profit is
$(V-P). As before, in addition to profits (or losses) that individuals make from
transactions, all Emissians will suffer a loss of profits equal to the amount of
the pollution costs imposed on each person by the production of ornaments.
Warm-Up Exercises
• Suppose that each lawn ornament that is
produced imposes a “pollution cost” of
$.50 on each citizen of Emissia. If 20 lawn
ornaments are sold, what will be the
“pollution cost” suffered by each Emissian?
• If there are 45 people in Emissia, what is the
total cost of pollution (to all Emissians
collectively)?
Warm-Up Exercises
• Suppose that in Session 1, a total of 20 lawn
ornaments are sold and that each lawn ornament
imposes costs of $.50 on each citizen. You are a
supplier with a Seller Cost of $20 and the best
offer you can get for a lawn ornament is $27. If
you sell the ornament at this price, what would
be your total profit (or loss) for this session?
What will your total profit or loss be if you
choose not to sell the ornament? [Don’t forget
to account for pollution costs.]
Warm-Up Exercises
• Suppose that in Session 2, Emissia has a population of
100 people. Each lawn ornament that is produced
imposes a cost of $.20 on each citizen. Suppose that
the government imposes a pollution tax on producers
of lawn ornaments in the amount of $10 for every lawn
ornament produced. The total number of lawn
ornaments sold is 40. If you make no transactions, you
will pay how much in “pollution cost”? What will your
share of the total revenue collected from the tax be?
What will your total profit or loss be?
Warm-Up Exercises
• The situation in Emissia is the same as described in the
previous question. Suppose that a supplier with a
Seller Cost of $10 meets a demander with a Buyer
Value of $30 and sells a lawn ornament to the
demander at a price of $25. Ignoring pollution costs,
what will the supplier’s after-tax profit from this
transaction be? What will the demander’s profit from
this transaction be?
Warm-Up Exercises
• In Session 3, suppose that you are a lawn ornament
supplier with a Seller Cost of $25 and suppose that you
received a “pollution permit” with your PIS. The most
that anyone will pay you for a lawn ornament is $32,
and the most that anyone will pay to buy your pollution
permit is $10. Should you use your pollution permit to
sell a lawn ornament, or should you sell your pollution
permit and not produce any ornaments? Explain.
Warm-Up Exercises
• Suppose that in Session 3, Alice who is a supplier with
a Seller Cost of $15 buys a pollution permit from Dave
and sells a lawn ornament for $50 to Charlie, who is a
demander with a Buyer Value of $60. None of these
three people makes any other transactions. A total of
20 lawn ornaments are sold in Emissia, each of which
imposes a pollution cost of $.20 on all citizens. In this
session, what is Alice’s profit? ….Dave’s?
….Charlie’s?