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?

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

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

Price
Consumers’ Gain
MSC
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.

Price
Supply Curve = Marginal Private Cost
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
How much individuals choose to consume.
Price
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
Price
MPC+tax
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 cost
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.

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.

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.
3. Reduce their emissions by more and sell

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.
3. Reduce their emissions by more and sell surplus credits.
In 2001 4.5 million tons of rights were traded within the company @ average price of $40 per ton.

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.

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.

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.
The local information was used in the right way.
There was an incentive to do the right thing not lie.

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).
Raises revenue and can eliminate other (worse) taxes.
May not need uniform treatment.
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.
Negotiated Outcome
Polluter
Polluted

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

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
• These each have probability ½.

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

• 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?

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

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 around.

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.