Download Externalities and the Environment

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?
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).
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.
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).
May not need uniform
treatment.
Raises revenue and can eliminate
other (worse) taxes.
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:
Buyer value
Low
40
Each cell occurs ¼ of
time, so expected
gains are
¼(5+0+5+30) = 10
Easy 5
Seller cost 35
Hard 0
60
High
65
30
5
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.”
Buyer value
Prices
Seller
cost
Easy
35
Hard
60
Low
40
37.50
High
65
50
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.