Externalities and the Environment. What is an Externality? When a person/firm does something that...

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 HarmfulConsumption Production

2-person Many personStock Flow

Affecting Utility Affecting Production

Public Private

Why this presents a problem

An externality implies: Social Cost = Individual Cost

Social Benefit = Individual BenefitThe 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

MSCMPC+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 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 : BPInstead 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 : BPInstead 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 ConsEfficiency (static) across different Difficult to get

rightpolluters.

Incentives to reduce pollution May not need uniform in the future (dynamic efficiency). treatment.

Raises revenue and can eliminate If already monopoly,

other (worse) taxes. then pollution underprovided

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

PolluterNegotiated 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

PolluterLegal 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

Low40

High65

Seller cost

Easy35

5 30

Hard60

0 5

Each cell occurs Each cell occurs ¼ of time, so ¼ of time, so expected gains expected gains are are ¼(5+0+5+30) = ¼(5+0+5+30) = 1010

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

Low40

High65

Seller cost

Easy35

37.50

50

Hard60

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.

• 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 earn½(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.