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 Harmful ConsumptionProduction 2-personMany person StockFlow Affecting Utility Affecting Production Public 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 Quantity of Coffee Price

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

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

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?

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

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

Quantity of Coffee Price MSV/Demand MPC MSC Consumers’ Gain

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

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.

Quantity of Coffee Price MPC Supply Curve = Marginal Private Cost

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

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

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

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

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

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

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 Marginal abatement cost Quantity of Abatement Marginal Private Damage Cost £ Costs/Benefits

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

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

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

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

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 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 surplus credits.

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 million tons of rights were traded within the 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 ProsCons Efficiency (static) across differentDifficult to get right polluters. Incentives to reduce pollutionMay not need uniform in the future (dynamic efficiency).treatment. Raises revenue and can eliminateIf already monopoly, other (worse) taxes.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 Polluted Polluter Set of Feasible Agreements

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 Polluted Polluter Outcome imposed by law

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

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. Polluted Polluter Legal Outcome

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

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

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

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? 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 Buyer value Low 40 High 65 Seller cost Easy Hard

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 – = 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.

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. Fundamental Issue

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.