No Such Thing as a Free Lunch: Principles of Economics (Part 76)

“Experience has taught us that material wants know no natural bounds, that they will expand without end unless we consciously restrain them. Capitalism rests precisely on this endless expansion of wants. That is why, for all its success, it remains so unloved. It has given us wealth beyond measure, but has taken away the chief benefit of wealth: the consciousness of having enough.”

― Robert Skidelsky Edward Skidelsky, How Much Is Enough? Money and the Good Life

Externalities, Public Goods, Imperfect Information, and Social Choice

(Part C)

by

Charles Lamson

Bargaining and Negotiation In a notable article written in 1960, Ronald Coase pointed out that the government does not need to be involved in every case of externality (Sir Ronald Coase, "The Problem of Social Cost," Journal of Law and Economics, 1960). Coase argued that private bargains and negotiations are likely to lead to an efficient solution in many social damage cases without any government involvement at all. This argument is referred to as the Coase theorem.

For Coase's solution to work, three conditions must be satisfied. First, the basic rights at issue must be clearly understood. To bring back Harry and Jake (our two dorm inhabitants we used as an example in last post), either Harry has the right to play a stereo or Jake has the right to silence. These rights will probably be spelled out in dorm rules. Second, there must be no impediments to bargaining. Parties must be willing and able to discuss the issues openly and without cost. Third, only a few people can be involved. Serious problems can develop when one of the parties to a bargain is a large group of people, such as all the residents of a large town.

For the sake of our example, let us say that all three of these conditions hold for Harry and Jake and that no room swap with someone like Pete is possible. The dorm rules established basic rights in this case by specifying that during certain hours of the day, Harry has the right to play his stereo as loudly as he pleases. Returning to Figure 2 in our earlier discussion and reintroduced below, suppose that under the rules Harry is free to choose any number of music playing hours between 0 and 8.

Because Harry is under no legal constraint to pay any attention to Jake's wishes, you might be tempted to think that he will ignore Jake and play his stereo for 8 hours. (Recall that up to 8 hours, the marginal benefits to Harry exceed the marginal costs that he must pay.) However, Jake is willing to pay Harry to play his stereo fewer than 8 hours. For the first hour of play, the marginal damage to Jake is $0.15, so Jake would be willing to pay Harry $0.15 in the first hour to have Harry turn off his stereo. The opportunity cost to Harry of playing the first hour is thus $0.15 plus the (constant) marginal private cost of $0.05, or $0.20. Because the marginal gain to Harry in the first hour is $0.50, Harry would not accept the bribe. Likewise, for hours two through five the marginal benefit to Harry exceeds the bribe that Jake would be willing to pay plus the marginal private cost.

After five hours, however, Jake is willing to pay $0.20 per hour to have Harry turn off his stereo. This means that the opportunity cost to Harry is $0.25. After 5 hours the marginal benefit to Harry of another hour of listing to his stereo falls below $0.25. Harry will thus accept the bribe not to listen to his music in the sixth hour. Similarly, a bribe of $0.25 per hour is sufficient to have Harry not play the stereo in the seventh and eighth hours, and Jake would be willing to pay such a bribe. Five hours is the efficient amount of playing time. More hours or fewer hours reduced net total benefits to Harry and Jake.

Coase also pointed out that bargaining will bring the contending parties to the right solution regardless of where rights are initially assigned. For example, suppose that the dorm rules state that Jake has the right to silence. This being the case, Jake can go to the dorm administrators and have them enforce the rule. Now when Harry plays the stereo and Jake asks him to turn it off, Harry must comply.

Now the tables are turned. Accepting the dorm rules (as he must), Harry knocks on Jake's door. Jake's damages from the first hour are only $0.15. This means that if he were compensated by more than $0.15, he would allow the music to be played. Now the stage is set for bargaining. Harry gets $0.45 in net benefit from the first hour of playing the stereo ($0.50 - private cost of $0.05). Thus, he is willing to pay up to $0.45 for the privilege. If there are no impediments to bargaining, money will change hands. Harry will pay Jake some amount between $0.15 and $0.45 and, just as before, the stereo will continue to play. Jake has, in effect, sold his right to have silence to Harry. As before, bargaining between the two parties will lead to five hours of stereo playing. At exactly five hours, Jake will stop taking compensation and tell Harry to turn the stereo off. (Look again at Figure 2 to see that this is true.)

In both cases the offer of compensation might be made in some form other than cash. Jake may offer Harry goodwill, a favor or two, or the use of his Harley-Davidson for an hour.

Coase's critics are quick to point out that the conditions required for bargaining to produce the efficient result are not always present. The biggest problem with Coase's system is also a common problem. Very often one party to a bargain is a large group of people, and our reasoning may be subject to a fallacy of composition (the error of assuming that what is true of a member of a group is true for the group as a whole).

Suppose a power company in Pittsburgh is polluting the air. The damaged parties are the 100,000 people who live near the plant. Let us assume the plant has the right to pollute. The Coese theorem predicts that the people who are damaged by the smoke will get together and offer a bribe (as Jake offered a bribe to Harry). If the bribe is sufficient to induce the power plant to stop polluting or reduce the pollutants with air scrubbers, then it will accept the bribe and cut down on the pollution. If it is not, the pollution will continue, but the firm will have weighed all the costs (just as Harry did when he continued to play the stereo) and the result will be efficient.

However, not everyone will contribute to the bribe fund. First, each contribution is so small relative to the whole that no single contribution makes much of a difference. Making a contribution may seem unimportant or unnecessary to some. Second, all people get to breathe cleaner air, whether they contribute to the bribe or not. Many people will not participate simply because they are not compelled to, and the private bargain breaks down---the bribe that the group comes up with will be less than the full damages unless everyone participates. (We discuss these two problems---the "drop in the bucket" and the "free-rider" in a later post.) When the number of damaged parties is large, government taxes or regulation may be the only avenue to a remedy.

Legal Rules and Procedures For bargaining to result in an efficient outcome, the initial assignment of rights must be clear to both parties. When rights are established by law, more often than not some mechanism to protect rights is also built into the law. In some cases where a nuisance exists, for example, there may be injunctive remedies. In such cases, the victim can go to court and ask for an injunction that forbids the damage-producing behavior from continuing. If the dorm rules specifically give Jake the right to silence, Jake's getting the resident advisor to speak to Harry is something like getting an injunction.

Injunctive remedies are irrelevant when the damage has already been done. Consider accidents. If your leg has already been broken as the result of an automobile accident, enjoining the driver of the other car from drinking and driving will not work---it is too late. In these cases, rights must be protected by liability rules, rules that require A to compensate B for damages imposed. In theory, such rules are designed to do exactly the same thing that taxing a polluter is designed to do: provide decision makers with an incentive to weigh all the consequences, actual and potential, of their decisions. Just as taxes do not stop all pollution, liability rules do not stop all accidents.

However, the threat of liability actions does induce people to take more care than they might otherwise. Product liability is a good example. If a person is damaged in some way because a product is defective, the producer company is in most cases held liable for the damages, even if the company took reasonable care in producing the product. Producers have a powerful incentive to be careful. If consumers know they will be generously compensated for any damages, however, they may not have as powerful an incentive to be careful when using the product.

Selling or Auctioning Pollution Rights We have already established that not all externality-generating activities should be banned. Around the world, the private automobile has become the clearest example of an externality-generating activity whose benefits (many believe) outweigh its costs.

Many externalities are imposed when we drive our cars. First, congestion is an externality. Even though the marginal "harm" imposed by any one driver is small, the sum total is a serious cost to all who spend hours in traffic jams. Second, most of the air pollution in the United States comes from automobiles (National Park Service). Finally, driving increases the likelihood of accidents, raising insurance costs to all.

While we do not ignore these costs from the standpoint of public policy, we certainly have not banned driving. This is also true for many other forms of pollution. In many cases we have consciously opted to allow ocean dumping, river pollution, and air pollution within limits.

The right to impose environmental externalities is beneficial to the parties causing the damage. In a sense, the right to dump in a river or pollute the air or the ocean is a resource. Thinking of the privilege to dump in this way suggests an alternative mechanism for controlling pollution: selling or auctioning the pollution rights to the highest bidder. The Clean Air Act of 1990 takes this approach by limiting the quantity of the emissions from the nation's power plants. To minimize the initial cost of compliance and to distribute the burden fairly, each plant is issued tradable pollution rights. These rights can be sold at auction to those plants whose costs of compliance are highest.

Another example of selling externality rights is in Singapore, where the right to buy a car is auctioned each year. Despite very high taxes and the need for permits to drive in downtown areas, the roads in Singapore have become congested. The government decided to limit the number of new cars on the road because the external costs associated with them (congestion and pollution) have become very high. With these limits imposed, the decision was made to distribute car ownership rights to those who placed the highest value on them. It seems likely that taxi drivers, trucking companies, bus lines, and traveling sales people will buy the licenses; families who drive for convenience instead of taking public transportation will find them too expensive.

Congestion and pollution are not the only externalities that Singapore takes seriously: the fine for littering is $1,000 (singaporecriminallawyer.com); for failing to flush a public toilet, $150 (businessinsider.com) and for eating on a subway, up to $500 (smrttrains.com).

Direct Regulation of Externalities Taxes, subsidies, legal rules, and public auction are all methods of indirect regulation designed to induce firms and households to weigh the social costs of their actions against their benefits. The actual size of the external cost/benefit depends on the reaction of households and firms to the incentives provided by the taxes, subsidies, and rules.

For obvious reasons, many externalities are too important to be regulated indirectly. Dumping cancer-causing chemicals into the ground near a public water supply is simply illegal, and those who do it can be prosecuted and sent to jail.

Direct regulation of externalities takes place at the federal, state, and local level. The Environmental Protection Agency (EPA) is a federal agency established by an act of Congress in 1970. Since the 1960s, Congress has passed lots of legislation that set specific standards for permissible discharges into the air and water. Every state has a division or department charged with regulating activities that are likely to harm the environment. Most airports in the United States have landing patterns and hours that are regulated by local governments to minimize noise.

Many criminal penalties and sanctions for violating environmental regulations are like the taxes imposed on polluters. Not all violations and crimes are stopped, but violators and criminals face "costs" for the outcome to be efficient, the penalties they expect to pay should reflect the damage their actions impose on society. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 313-315*

end