JOURNAL OF ENVIRONMENTAL ECONOMICS AND MANAGEMENT 11, 173-179 ( 1984)

Depletable Externalities and Pigouvian Taxationl

A. MYRICK FREEMAN III

of Economics, Bowdoin College, Brunswick. Maine (MOI I

June 13, 1983; revised *ptember 1983

In bmk Baunx)l and Oats ["The neoty of Environmental Policy:

Public Outlays, Quality of Life," Prentice-Hall,
that

istic in &termining Cliffs, N.J. (1975).) argue

xgative depletabkanexternalityextemalityisdepletabkrequirsnot(private)only aorchargeundepletableortaxon(public)the is the key character-
extemabty but a pricing pattem. They argue that unlike the undepktable cas* a
or
It is of the
that to the victim in order to Ehieve Pareto
key charEteristic determining whetber comFnsation of victims is
for
is
the depletability of the extemality but whether tlx victim can x»tlssly
control or limit the ammnnt of the damaõng substance

One of the major themes in Baumol and Oates' [1) excellent treatment of the
theory of externalitis is the distinction between depletable and undepletable exter-
nalities and the implications of this distinction for efficient pricing or Pigouvian
taxation. fie
that Baumol and Oates attach to this distincüon has been
commentd on by several of the reviewers of this
for example, Collard [21,
[41, Morgenstem [5), and Randall [6).
An undepletable extemality is in the nature of a public
or public bad.
Baumol and Oates (B & O hereafter) define an undepletable (public) extemality as
one "in which the amount of the extemality consumed by one individual
not
the amount available to any Other person or firm" [1. p. 35). In contrast, for
B & O, "The distinguishing characteristic of the depletable [private] externalities
case is the
in the amount of the external
that remains for everyone
else whenever some individual or firm increases its consumption of that item" [l, p.
46, word in brackets
They show that in the
of undepletable externalities,
optimal
calls for a per unit tax (subsidy) on the generator of a
negative (positive) extemality but a zero compensation (price) to those
by it.
But they argue that in the case of a depletable externality efficient rsource
allocation calls for a single price per unit of the extemality paid by (to) the generator
of a negative (psitive) extemality and paid to (by) its recipient.
Unfonunately this conclusion is not correct. ñis is
although the intemal
logic of their
is
it is not a
of an externality as they have defined

Profesor of Economics, Collese. This note wu prepard while was Visitinc Profawr of
EcMjomis at
University of Washington. I have helpful from Gardxr Brown, Thomas
Oates. V. Keny Smith, William Stran& and r:etenberg. I
gratefully
the supprt of the University of Washington•s Pr gram in the R%ulation
of Natural by a grant from the Alfred P. Sloan Fou:xlation to tix Ikpartrnent of

Economics.
173
$3.(1)

Ccmnght 1984 by Press. Irw

All fichas o' in anv form rcxrved

174 A. MYRICK FREEMAN

the term. In this note, I develop a of the optimal taxation of a depletable

extemality which is consistent with B & o's definitions. I show that there is no
fundamental difference in the properties of optimal tax/price schemes for depletable
and undepletable extemalitis. 'Ihe difference in tax/price prescriptions that B & O
find arises
"externality" they in their model meptors are fre to choose the quantity of the
But this fredom is not consistent with their definition of
an extemality. B & O define an externality as follows:
An extemality is prsent whenever some individual's (say A's) utility or production relation-
ships include real (that is, non.monetary) variables, whase values are chosen by others
(persons, corprations,
without particular attention to the effects on A's welfare." (l,
p. 17, original italics omitted, emphasis added by the authorl
As B & O say, definitions are a matter of taste and convenience. But they have
persuaded me that their definition is to be preferred to others they discuss on the
grounds that it focuses on the
or physical
of the interconnections
among wonomic agents and leaves appropriate institutional responses and policy
recommendations to be
from the definition.
B & O reach their erroneous conclusion regarding taxation of depletable
externali-ties because they apparendy overlooked a key feature of their definition of
an externality—that the
has no control over the amount received.2 To derive
the properties of the optimal price structure, B & O differentiate the constrained
expenditure and profit functions of individuals and firms with respect to their choice
variables. And since B & O take derivatives with respect to the quantities of the
extemality rmeived, they are in effect assuming that individuals have some choice
over these quantities. In fact in their model the role of the prices paid to recipients of
negative externaliües is to induce
to accept the optimal quantities. And
must be charged for a beneficial externality to prevent them from trying to
take too much. fie prices are
to get the "market" to clear.3 In B & o's
model the prices arise so as to regulate
choices, not because of the absence
of choice inherent in an externality. If individuals cannot choose the quantiües of
the externality they
there is no need to include a price in their constraint set.

I Will now derive the efficient or Pareto optimal prices and taxes for a negative
depletable extemality, that is, a variable produced by fims which reducs individual
utilities, the quantities of which aE chosen by profit-maximizing firms, and for which one
individual's absorption of a óven quantity (over which he has no control)
reduces the quantity to be absorbed by others.4 B & O expr#.s some doubt as to

2 It is imprtant to disünguish between control of the amount and costly control (or
influence) over tl:r effects of the externality. For example, pmple may be able to reduce the loss of utility

caused by expsure to air ponution through

the magnitude of marginal dama.gs and therefore the a.mount of the optima]
mitigaüng or averüng activitis. 'ThesechargedEtivitistoaffectthe
generators of the extemality, On this se Courant and Porter [3). But as shown bebw, t.he posibility of
mitigaüng
not alter
conclusons regarding prices to extemality redpients.
3 B & O may have %nsd the nature of the
and the real reason why their two
yieued
different
about
p. 18, note 13, and p. 23. But tbey explicitly maintained their
original definition of an externality,
'B & O treat the more general cag in which both individuals and firms are affected by the extemality.
 DE.PLETABLE EXTERNALITIES

whether there are any real cases of negaüve depletable externalities. Acid
deposition on land
to fit the definition. Each pound of sulfur emitted to the atmosphere
must land somewhere, and if the quantity falling on A's land incrases, there is less
to fall elsewhere. 'Ihe quantity of acid deposition falling on a parcel of land of given
size deFnds on the total anissions of
and on the pattem of atmospheric
transformation and transprt. No rwipient can influence the extent to which he
"deplets" the extemality. Thus depletability is irrelevant for optimal pricing.
Following B & o's notation for the most part:

x,J — the amount of (resource) i consumed by individual j. (1 =

— the amount of (resource) i (usa) by firm k, (i
r, — the total quantity of rsource i available to the economy,
Sk — the quanüty of the extemality produca by firm k, measur«l in physical
units, e.g., tons of sulfur,
s
the quantity of the extemality
by individual j, also measured
in physical units,
and Ejs,
S — EkSk.
-me utility and prcñuction relations are
uJ(x
, Xn„Sj)
and

The conditions for a Pareto optimum can be found by

1
maximizing
, x ni, Si)
to:

(1)
uJ(x
(2)

h
(3)

and
h
(4)

where h, and a, Will be the mulüpliers on the constraints (1), (2), and (3).
To solve the problem, we must how the total emissions are distributed
among individuals. For the moment, let us assume that emissions from all

mix in the
and are then distributa so that each individual
where the a, are Éven by some atmospheric dispersion
and E;t-la, l.
Constraint (4) can now be entera in (1) sinces s, — ajEk-
 can be
thrm:gb the analysis of
simpler case in which only individuals are
the cal", for example. if all fims were
s This wmdd at the pint in .spwe.
176 A MYRICK FREEMAN

The Pareto optimum ares

(5)

(6)
m 7

(7)
1-1
Condition (7) is of geatst interest. It rquires that each firm's marginal cost of
raucing emissions qual the aggregate marginal damage that a unit of emission
causes as it is disprsa across the population. Since the Sj are determined given
EkSk, there is no
goveming the optimum distribution of S across the
populaüon, In this
the undepletable and depletable
are essentially
similar. It should be no surprise that the optimal price/tax schema are also the
same.
Following B & O, we write exFnditure minimization and profit maximization
exprasions for individuals and firms, including experimentally
on
and s, ,
and solve them to find the prics that make the maximization and minimi.zation
conditions corrspond to the Pareto optimum conditions. Individual j wishs to

E + p„SJ + — uj(•)).
But sinx s. is not a variable for the individual, p, plays no role in achieving
Pareto opumality. Firm k wish# to maximize
n
EPiYik - + Bkfk(•).

for:

Pkflk (all i)
and

- Bkfsk,.
Comparing thae quations with (6) and (7) shows that the market Will reach Pareto
optimality if:

and

(8)
 'For simplicity, 1 usunx an interior solution.
'SubEtipts uj f' demte partial derivatives with respect to the variabls. Note also
that pa, fs., are an xgative.
 DEPLETABLE EXTERNALITIES 117

Firms should be for their outputs of the negative externality, but the price
to recipients is irrelevant to Pareto optimality.8

I now consider several and extensions of the basic of the

precaing section. The first extension is to recognize that there is a sense in which
individuals do have
affects their utility level. Theycontrolmightoverbe theableextenttoplaceto insulationwhichnegativeintheir externalityhomesto
reduce the impact of aircraft or traffic noise; they might be able to counter the
posible adverse effect of acid rain by applying fertilizer or lime to their gradens; or
they might be able to
their inhalation of air pollutants by installing
air condiüoning and filtration
Of course these mitigating activities are
themselves costly; and even if they
against the extemality, there is a
loss of utility due to the diversion of resources away from Other consumption.
'Ihe pssibility of mitigating behavior can be
in the sp"fication
of the utility function. First, suppose the utility function is strongly separable in Sk.
The
would be independent of
The individual could not alter the marginal
damage caused by Sj by any Change in the levels of goods consumed. Mitigating
behavior would not be possible. But if the utility function were not separable in s/ ,
then the marginal damage of Sj depends on 8. The individual can reduce the
marginal damage by increasing his consumpüon of some mitigating
(and
because of the budget constraint
his consumption of some Other
These possibilities were implicit in the precaing model and can be made explicit by
writing the relevant Pareto optimum condition (7) and optimal Pigouvian tax (8) as:

(7')

E ajÀju{ (x/ ; s,) (8')

If individuals can the extent to which a óven negative extemality Will

damage them through mitigating behavior, then these possibilities must be taken
into account in measuring margnal damages and establishing the optimal tax on
Sk. But this possibility is not related to the distinction
depletable and
undepletable externalities. And it d(ES not alter our conclusion that compensation
for damages is unnecessary for Pareto optimality.
Now let us relax the implicit assumption of
mixing of emissions and
assume that it is possible to trace each unit of emission from its source k to its
receptor j. For simplicity let the
be dacribed by:

8 nis is more accurate than saying that the optimal price to recipients is zero. Any psitive or uxgative p,
creates a form of nondistorting lump sum tax or subsidy with no efficiency implications.
9 On this possibility
178
A. MYRICK FREEMAN

where sjk is the quantity of s received by j which can be attributed to source k.

Thus:
h

Substituting this in (1) and solving for the Pareto optimum conditions yields among
others:
h
E ajkSkÀjUJs, =
Since the Pareto optimum conditions involve a set of bilateral relationships betw#n
every possible source-rwQtor combination, it might be possible to define property
rights and allow bilateral exchanges to be the means of achieving an optimum. Aside
from large numbers and likely high transactions costs, the principal barrier to a
market solution is the nonseparability of the left-hand side of (7"). That is, unless uJs,
is constant, the price that k would pay j (or be paid by j) depends not only on k 's
emission, but also on the total of all Other emissions reaching j.
If all bargains are precluded by transactions costs or by regulation, the pricing
solution is clear. Each source should be charga a unit tax given by the left-hand
side of (7"). With differences among receptors and different ajk's, each source's
price is likely to be different. But again since individuals cannot choose the
quantities to be received from any sources, prices to individuals have no role to play
in achieving Pareto optimality.
Finally assume that each source can control the destination of its emissions, i.e.,
that firm k can choose its ajk
to Ej-lajk
. = 1. In practice a firm might be
able to choose whether to emit a substance to the air, scrub it from its exhaust gas,
and discharge the substance into a river, or deposit it as a sludge in a landfill site. If
firm k can
the distribution of
among individuals through its choice of
discharge media, location or height of smokestacks, etc., then it should be faced with
a set of differential taxes that
the differencs in marginal damages caused by
its choice of where and how to discharge the substance. But the general nature of
the pricing rules is not
by this complexity.

IV.

In summary, the principal conclusion to be drawn from this analysis is that the
distinction
depletable and undepletable externalities is unimportant, at
least as far as the basic features of the optimal Pigouvian tax policy are concerned.
The asymmetry between the price paid by the
and the price paid to the receptor
that B & O found in the case of undepletable extemalities is also present in the case
of depletable extemalities, at least when both types of externalities are analyzed in a
common framework with a consistent set of definitions. And since the essence of the
extemality problem is that individuals cannot
the level of the externality
them, prices on or compensation for the externality received have no role to
play in directing the
of extemaliti# toward a Pareto optimal or efficient
allocation.
 DEPLETABLE EXTERNALITIES 179

REFERENCES
l. W. Baumol and W. Oates, "ñe Theory of Environmental Policy: Externalities. Public Outlays, and
the Quality of Life," Prentice-Hall,
Cliffs. N.J. (1975).
2. D. Collard, Review, Econ. J. 655-656 (1975).
3. P. Courant and R. Porter, Averting expenditure and the cost of pllution, J. Enoiron. Econ. Manag. 8.
321-329 (1981).
T. Crocker. Review, Land Econ. 52. 255-259 (1976).
5. R. Morgenstern, Review, J. Econ. Lit. 14, 66-68 (1976).
6. A. Randall. Review,
Econ. 52. 260-263 (1976).