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
Consumption Production
2-person Many person
Stock Flow
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
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?
 Consumers’ Value For Unregulated

MSC

Price
MPC

MSV/Demand

Quantity of Coffee
 Consumers’ Value at social optimum

MSC

Price
MPC

MSV/Demand

Quantity of Coffee
 Consumers’ Gain

MSC

Price
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.
 Supply Curve = Marginal Private Cost

Price 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
MPC+tax

Price 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

Marginal Social Damage Cost

£ Costs/Benefits
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).
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 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.

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 Cons
Efficiency (static) across different Difficult to get right
polluters.

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 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:

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

some intuition. Imagine
Low High
that we agree that we will
both say our “type”, and 40 65
then we will build the Easy 37.50 50
project when it makes Seller 35
sense, and set prices to cost
“split the difference.” Hard 0 62.50
60
 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.