Module 3 The economics of climate change 3
module The The economics of climate change 64 fail to generate a Pareto-optimal situation. This This situation. Pareto-optimal a generate to fail two factors,the these combination to of markets emit greenhouse gases into the atmosphere. Due over- consequently and decisions, their making when account into externalities negative take not do agents Economic system. economic the they cause are externalto any accounting within be- externalities and welfare social from detract they because Negative 3.2). Section (see nalities them. Second, GHG emissions are negative exter ket economies because countries tend to overuse mar in “efficiently”be exploited cannot sources gases greenhouseinto the atmosphere at any time. Open-access re of - amount any release can thereforecountryany use, and its constraints on source (see Section 3.1). As such, there are no legal - pri vate goods,the atmosphere is an open-access re being - commodities all of assumption the to contrary First, met. not are assumptions two because occurring failure market a such of result - the is change climate that shows 3 Section mal. iscalled a iswhat This failure.”“market opti- socially not are that outcomes generate and fied; if these assumptions are not met, satis- markets fail are assumptions certain that provided up holds view.only of result However,theoretical this efficient way and thus optimallyfrom a social point competitive markets allocate resources in a Pareto- fully theory, in that, shows efficiently.It allocated are resources whether evaluate to used efficiency Pareto of concept the and economies market ing - describ model theoretical standard the troduces in- It allocations. optimal and markets on theory economic of concepts basic the reviews 2 Section this question. to answer module aim problems like climate change exist? Sections 2 and 3 this of environmental severe that possible it is how efficiently, resources allocate markets If change. climate as such environment the on effects negative important to leads behaviour ficient, way. the At same time, however, economic ef i.e. optimal, that an in resources allocate markets stipulates theory economic Neoclassical those solutionsare known. well though even problems these to solutions implement to ficult climate change, and clarifies why can be so it dif transboundaryenvironmental problems, as such of occurrence the explains theory economic how tribute to change the climate. This module shows con- activities human how showed and change climate behind science climate the explained 2 Module interdependent. are environment the and economy the because climate the influence can activities economic that showed 1 Module Introduction 1 - - - - Additional reading material can be found in Annex 1. 3. Module in introduced issues the covering 5 tion Sec- in questions discussion and exercises several find will readers process, learning the support To • be to considered is change climate why • Discuss • • • • At the end of this module, readers should be able to: waysto fostertify cooperation amongcountries. iden- to us allow that models theory game from The section concludes by drawing several lessons optimal.socially not is that outcome an to leads This emissions. reducing to contribute not and that countries have strong incentives to free-ride is action collective of failure the of cause main the that shows It countries. among interaction strategic analyse to used are that concepts ory the- game introduces section difficulty, the this illustrate To good. public global a with dealing when achieve to difficult extremely is operation co- However,such needed. is cooperation tional interna- change, climate of threat the eliminate to actions take single-handedly can country no As 3.1). Section (see benefits non-excludable and non-rival has that good” “public global a mitiga- is tion change climate that shows It change. of governments and societies to mitigate climate gates how economic theory explains the inability investi- 4 Section issue. the solve to decades for struggling been has community international the change, climate mitigate could terventions in- policy how time some for known been has it change.climate mitigate to needed Even though Since markets have failed, policy interventions are failure market biggest inhumanhistory. gives to rise climate change, considered to be the deed the case, then why do markets sometimes sometimes markets do why then case, the deed that marketsallocate resources efficiently. stipulates in is this If theory economic Neoclassical andPareto efficiency 2 climate changemitigationpolicies. implement to struggling been internationalhas community the that fact the explain mists econo- how analyse to tools theory game Use failure market the biggest inhumanhistory; ative externalities; Explain why greenhouse gas emissions are neg- an open-accessresource; Explain why the atmosphere is considered to be failures;market define and hold not the does theorem welfare first which under conditions the Understand State the implications of the first welfare theorem; competitiveThe markets model -
The economics of climate change 3 fail to do so, producing highly inefficient out- modelled. Economists have developed a standard comes leading to environmental problems such model of a competitive market economy,41 which 41 Going into the details of module as climate change? To answer this question we we will now briefly introduce and which will the microeconomic foun- first have to understand why economic theory serve as a starting point to understand how eco- dations of the competitive market model is beyond concludes that markets produce efficient out- nomic theory explains the occurrence of climate the scope of this material. comes, in particular, understand (a) how econo- change. Interested readers may refer mists conceptualize market economies, and (b) to standard microeconomic how economists evaluate the efficiency of market In this standard model, the economy is assumed textbooks such as Varian economies. This section clarifies these two points to be composed of economic agents (firms and (2010). Additional readings can also be found in Annex 1. and shows that, given certain conditions, eco- households) acting purely in their own self- nomic theory predicts that markets indeed pro- interest – i.e. trying to optimize their behaviour duce efficient outcomes. Section 3 subsequently to achieve the outcome that is best for them. In shows that in the context of climate change, other words, firms try to maximize their profits some of these conditions are violated, and there- while households try to maximize their utility fore markets fail to achieve efficient outcomes. (i.e. consume a mix of goods and services that makes them as satisfied as they can be on a giv- 2.1 A simple model of market economies en budget). The model assumes that there are many different markets, one for each commodity. Economic processes are inherently complex and Each competitive market connects demand (how difficult to understand. Economists thus rely on much households are willing to pay for the com- theoretical models of the economy to improve modity) and supply (how much firms want to be their understanding of these processes. Eco- paid to produce the commodity), thereby deter- nomic models are theoretical constructs that mining how much of the specific commodity is aim to represent different aspects of economic produced. In such a competitive market, the price processes in a simplified way. They therefore rely of a commodity adjusts until demand equals on assumptions that might not necessarily hold supply. This is called equilibrium. Put differently, a in reality. Nevertheless, the models are very use- market is in equilibrium if the sum of the quanti- ful tools because they shed light on complex eco- ties of commodities that households want to buy nomic mechanisms and their relationships with at current prices equals the quantities of com- the environment. Market economies, currently modities that firms want to produce at current the dominant form of economic organization prices (see Box 12 for a graphical illustration of an (Cohen, 2009), have been extensively studied and equilibrium in a single competitive market).
Box 12 Equilibrium in a single competitive market Figure 30 displays a single competitive market for a normal good and shows the demand and supply curve for this particular good. The demand curve relates the quantity demanded by consumers to the market price. It is downward sloping, meaning that the cheaper the good, the more of it consumers are willing to buy. The supply curve relates the quantity supplied to the price and is upward sloping, meaning that the higher the price firms can charge, the more they are willing to supply. The market is in equilibrium at price P* and cor- responding quantity Q*, as this is the only point where demand equals supply. Note that given the supply and demand curves, this is the only equilibrium in this particular market. For any other price, supply does l l not equal demand. To see this, look for instance at price P : at this price, consumers demand Q d, but producers l are only willing to supply Q s. This situation is clearly not an equilibrium, as the quantity demanded is higher than the quantity supplied.
Figure 30 Equilibrium in a single competitive market
Price Supply
P*
Pl Demand
l l Q s Q* Q d Quantity
Source: Author.
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module Arrow (1951). was first formally proved by endowment, that theorem a transfersthe initial wealth of afterby amarket lump-sum canbeachieved equilibrium any Pareto-efficientthat welfaretheorem, stating foundations the second of the (1944) also outlined welfarefirst theorem. Lerner ly) provethe the existenceof to(graphical economist - first 43 42 The economics of climate change optimality. economic efficiency or Pareto sometimes also referred to as Lerner (1934, 1944)wasthe Pareto efficiency is 66 commonly used tool is called Pareto efficiency,Pareto called is tool used evalucommonly- most to The resources. of used allocations different ate are tools conceptual Various efficiency 2.2 Pareto section.the next duced in – intro- efficiency Pareto – efficiency specific of concept very a and model market competitive the using by question this answer to tried have Economists costly. is improperly them locating know,to however, al - and scarce areresources as important is This resources. these allocating in are economies those efficient how about silent remains resources, it allocate economies market how understand to us allows model the While only a single commodity market, is in equilibrium. economy, market not whole and the state, this in is called a competitive equilibrium. Put differently, prices of set corresponding the and commodities are in equilibrium, then the markets resulting allocation of commodity individual all con- and straints, budget their given utility their maximize consumers all profits, their maximize firms all If resourcesto bePareto-optimal. issaid made and no more are available, the allocation of it? been have improvements do Pareto such all When not why situation, a “Pareto-improve” could you if i.e. person, another of situation the deteriorating without person one least at of tion situa- the improve could you if all, Aftersirable. de- not priori a are Pareto-inefficient allocations location iscalled aPareto-efficient allocation. al - an off worse person another making without off better persons more or one make to way no is off is called a Pareto-inefficient allocation. there If worse person another making without off better persons more or one make to way a find can one Vilfredo Pareto. An allocation of economist resources Italian in which century 19th the after named rc ta smoe ol b wlig o a fr n xr ui (hc wud e pie lgty below slightly price a be would (which unit extra an for pay to willing be would someone that price Why is the resulting equilibrium production amount considered to be Pareto-efficient? Suppose that in- quantity equilibrium that the producing Suppose of Pareto-efficient? stead be to considered amount production equilibrium resulting the is Why to supplyanextraP* unit. amount an pay to sumers topaid producethe good. In an equilibrium, demand and supply are of balancedthe con willingness that so - taking into account how much consumers to arepay willing for the good and how much suppliers have to be competitive market. As we have already seen, competitive markets the totaldetermine quantity produced by a in good normal a of curves demand and supply displaysmarket. 31 Figuresingle a in output production of example Pareto-efficient,considered the be using can equilibria market why at look intuitive an take us Let would be willing to produce an additional unit and sell it at a price slightly above P above slightly price a at it sell and unit additional an produce to willing be would Box 13 A Pareto-efficient for an extra unit is equal to the willingness of suppliers to be paid the amount amount the paid be to suppliers of willingness the to equal is unit extra an for P* level ofproduction inasinglemarket , suppliers would produce less, say,less, produce would suppliers Q*, 42
ple ofproduction inasinglemarket. exam - the through this illustrates 13 Box else. one some- harming without improved be can position constitutes a social optimum from which nobody’s interest will achieve an allocation of resources that self- own their in purely acting agents economic of composedmarkets that economics.implies in It results theoretical central most the of one is and The Wealth of Nations in 1776 of an “invisible hand,” in Smith’sconjecture Adam formalizes thus orem Pareto-efficient allocations. are equilibria markets’ competitive satisfied, are fare theorem states that, as long as some conditions wel- case.first the The theory,indeed is nomic this resources allocate efficiently. eco- neoclassical to According model, market competitive the by elled mod- as economies, market whether evaluating for allows efficiency Paretolimitations, its Despite andPareto efficiency 2.3 biguously improvesthe welfare ofasociety. unam- that way a in changed be can allocations (Mas-Colell not or fully waste- resources allocating is society a whether equality. determine or only tice can criterion The jus- optimize that allocations identify to us low al- not does efficiency Pareto Thus,disgusting.” perfectly be still and optimal Pareto be can omy intocutting the pleasuresthe rich... of [A]n econ- without off better made be cannot starvers the as long starvation,as near are others and luxury in rolling are people some when efficient “even an economythat by writing plicit may be Pareto- ex point this made 22) (1970: Sen Amartya able. to evaluate which of the two allocations is prefer unable is criterion Pareto-efficient, the are tions efficient, - alloca is limits. two location its has If it al- an not or whether evaluating for benchmark While the Pareto-efficiencycriterion is useful as a Competitive market ., 1995) and whether and 1995) al., et equilibria Q 43 l . Then some producer some Then . The first welfare the- welfare first The S l , but well below the below well but , P d l ). ). - -
The economics of climate change 3 Box 13 A Pareto-efficient level of production in a single market module This would clearly be a win-win scenario, as by producing and exchanging that additional unit, at least these two persons would be better off. The same holds for all quantities below Q*. Thus as long as less than Q* is produced, at least one person could be made better off by increasing total production. Would producing a quantity greater then Q* also be a Pareto improvement? The answer is no. As the price any supplier asks for an extra unit produced would be higher than any consumer’s willingness to pay for that unit, nobody would buy this extra unit, and thus no person would be better off. At the same time, the supplier producing the extra unit that cannot be sold would be even worse off. Therefore, only the market equilibrium allocation Q* with the corresponding price P* can be considered to be a Pareto-efficient allocation. This is an intuitive illustration of the claim that competitive markets determine a Pareto-efficient amount of output.
Figure 31 A Pareto-efficient level of output in a single competitive market
Price Supply
l P d
P*
l P s Demand
l Q s Q* Quantity
Source: Author's elaboration based on a similar discussion in Varian (2010: 310–12).
The first welfare theorem depends, however, on are no externalities; and (f) all commodities are a series of assumptions that Perman et al. (2011: private goods.44, 45 In reality, these assumptions 44 In addition to the assump- 103) call “institutional arrangements.” These ar- are often violated (Sandler, 2004). Consequently, tions highlighted in this rangements have to be satisfied or the first wel- markets fail to achieve Pareto-efficient alloca- section, there is an additional technical assumption on fare theorem does not hold and competitive mar- tions and economists speak of market failures, consumer preferences called kets do not produce socially optimal situations. which can potentially have devastating conse- local nonsatiation of prefe- These assumptions require that (a) markets exist quences and lead to situations that are not so- rences, which also has to be for all goods and services; (b) these markets are cially optimal. As we will see in Section 3, climate satisfied for the first welfare perfectly competitive (no agent can influence the change is the result of such a market failure. theorem to hold (Mas-Colell et al., 1995: 549–50). price); (c) all agents have full information on cur- Some have even argued that climate change rent and future prices; (d) private property rights is the biggest market failure in human history 45 Note that, strictly spea- exist for all resources and commodities; (e) there (Stern, 2007). king, assumptions (e) and (f) are already implied by Short summary assumption (d). If enforceable private property rights for all Section 2 reviewed basic elements of economic theory that are needed to understand how economic theory resources and commodities explains climate change. The section started by introducing the standard model of a competitive economy do exist, then all benefits and discussed the concept of market equilibrium. It then briefly introduced the Pareto-efficiency criterion and/or costs accrue to the agent holding the property used to evaluate different allocations of resources. Finally, it showed that markets allocate resources in a right for the commodity or Pareto-efficient way provided that certain conditions are satisfied, but fail to do so if these conditions are not resource. This implies that met. These so-called market failures are at the heart of economists’ explanations of the occurrence of climate there would not be any change and are analysed in greater detail in the following sections. externalities and only private goods. However, we follow Perman et al. (2011) and list these assumptions separately for the sake of clarity, as we will discuss assumptions (e) and (f) extensively in sections 3.1 and 3.2.
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module produced. or aprivate goodispublicly is privately produced and/ apublicgood that possible public orprivate agents). is It way agoodisproduced (by and excludability, the to not ofrivalry property publicness bute “public” the refersto - the attri that understand 48 47 46 The economics of climate change “rivalry.” bility” asanequivalent of term the 2012) use “divisi - (e.g. Tietenberg andLewis, types of these goods. of types the differentan overview on It is important to to isimportant It SeeSanders(2004)for Note that some scholars somescholars that Note 68 3.1 failure. ofamajormarket the result to be ered consid- is change climate why show and detail in violations both discuss we 3.2, and 3.1 Sections In the atmosphere that exacerbates climate change. in accumulation GHG growing to leading gases, greenhouse over-emit agents economic and fail, markets up, hold not does theorem welfare first the violated,are assumptions two these Because to aPareto-inefficient outcome. example of a negative externality that again leads As we will see in Section 3.2, GHG emissions are an externality.any of absence the concerns (e), tion former. The second violated assumption, assump- the Pareto-efficiently handle cannot markets and goods, private “normal” from different very are resources open-access see, will we As violated. is assumption this 3.1), Section (see resource access open- an is atmosphere the since - pri goods.vateBut be to have goods all that is (f), assumption assumptions, these of first The theorem. welfare first the of assumptions the viola- underlying two to of tion due is finding empirical this that maintain Economists 2014a).(IPCC, change mate cli- induced human- such of existence the wards to- points evidence empirical current However, occur.human-induced climatechangewouldnot world, theoretical ideal this In welfare.else’s one some- harming improvedwelfare be without can duce a socially optimal situation in which no one’s Pareto-efficient way,a proin i.e. - resources locate self-interestal- own their in economic purely acting agents of composed markets theory, nomic eco- ofneoclassical theorem welfare first the to according that, showed module this of 2 Section 3 (Sandler,Perman 2004; excludability and rivalry consumption: their benefits of the characterize that criteria two ing us- public or private as classified be can Goods this fact.the consequences of understand us help then will section good.private The a not repository,GHG is a as function its mosphere,in at the that show will goods.private section This non- involve systems market if fail to tend but goods,private with deal they if allocations timal Pareto-op- achieve markets that us tells Theory failure inhumanhistory f osmto ae xldbe hn n can one when excludable are consumption of else’sBenefits consumption.somebody of pense ex the at is consumption individual’s one that meaning individual, one by consumed be only can good a of areconsumptionrivalunit a when Climate atmosphere: The change: Anopen-access resource
The , 2011). al., et greatest 46 Benefits of Benefits
market - - ent types of goods, of types ent differ these all discuss not will we purpose, our of goods called common-pool resources. They are class larger a of part are resources Open-access the atmosphere belongs.which to – resources open-access – type particular one degrees of publicness (Perman publicness of degrees different with words, other in or excludability, differentwith goods of rivalryety degreesof and two extreme cases, the literature identifies a - vari public goods are thus very different. Within these pure and private pure governing economics The benefits ofnational defence are also non-rival. the Thus,defence. of level same the consuming citizen another of possibility the slightest the in diminish not does she or he level,defence vided pro- the consumes citizen a If non-excludable. level). Hence,the benefits of national defence are defence provided the of benefits the consuming from words, other (in military the by protected being from excluded be can country the within is provided by the military, no citizen who is living defence of level certain a defence.Once national good: public pure a of example classical a with this illustrate us Let unit. same individual the consuming another of possibility the affecting without good the of unit particular a consume can individual an that means gifted.Non-rivalry titlements can be neither identified nor traded or fromgood,the consuming consumptionand en- excluded be can nobody that means cludability public arenon-rivalgoods non-excludable.and Non-ex pure of benefits The (1954). Samuelson Paul economist American the by 1954 in scribed pure are goods de- first were goods of types goods.public These private pure of opposite The life,in ourdaily therefore is apure private good. consume we goods most to similar Bread, able. are exclud- loaf the consuming of benefits the words,other bread;in of loaf particular a eating from excluded be can loaf the consume to right the owning not individual any that means This law.by punishable is and stealing considered is else everything but gifted, or traded be can loaf the right to consume it. The right to consume the has thus and unit specific a owns who identify can one and units separable in comes bread as time,excludable,completely breadis consuming same the rival.At completely are bread of loaf a anybodyby else. Thus, of benefits the consuming eaten be cannot and destroyed is loaf bread,the privategood: bread. of loaf a individualeats an If pure particular a at look us concept, the let trate completely rival andexcludable benefits. - illus To having as defined are goods private the Pure good. consuming from person another prohibit 48 but rather concentrate on concentrate rather but ., 2011). al., et 47 For - - The economics of climate change 3 defined by Tietenberg and Lewis (2012: 629) as nomic agents make their decisions to exploit the “common-pool resources with unrestricted ac- atmosphere’s GHG repository function solely on module cess.” Because scholars are still struggling to un- the basis of their own benefits and costs. By do- ambiguously define common-pool resources, we ing so, they ignore the negative impact their GHG will follow Ostrom (2008: 11) who defines them as emissions have on others. This leads to a situa- “sufficiently large that it is difficult, but not im- tion in which no agent has an incentive to reduce possible, to define recognized users and exclude its GHG dumping activities and to conserve the other users altogether. Further, each person’s use atmosphere’s capacity to absorb greenhouse of such resources subtracts benefits that others gases. might enjoy.” Thus, the benefits of consuming common-pool resources are rival (which distin- 3.2 Greenhouse gas emissions: A negative guishes them from pure public goods) but ex- externality problem cludable only with difficulties. If no individual or group owns a common-pool resource or is able Section 3.1 showed that market economies over- to exercise full control over such a resource, the use the GHG repository function of the atmos- resource is called an open-access resource. Exam- phere because they cannot efficiently manage ples of such open-access resources are fisheries, open-access resources. In addition to the open- forests, or the atmosphere. access problem, there is a second related factor contributing to the overuse of the atmosphere’s To be specific, the atmosphere is an open-access GHG repository function: emitting greenhouse resource with respect to its function as a reposi- gases is a negative externality problem. This is tory of GHG emissions. Everybody can use the an additional reason why markets fail and hence atmosphere to dump their GHG emissions free climate change occurs. of charge, and it is difficult (although not impos- sible) to restrain this usage. Thus, the benefits of An externality exists if actions by one economic using the atmosphere’s function as a GHG repos- agent unintentionally affect other agents. To be itory are only partly excludable. Moreover, if firms more precise, according to Perman et al. (2011: and individuals use the atmosphere as a GHG re- 121), an externality occurs if “the production or pository, other firms and individuals cannot do consumption decisions of one agent have an im- the same without causing serious negative envi- pact on the utility or profit of another agent in ronmental consequences like climate change. In an unintended way, and when no compensation/ that sense, the benefits of using the atmosphere payment is made by the generator of the impact as a GHG repository are rival. to the affected party.” A priori, externalities can be positive or negative.50 Whereas positive ex- 49 Actually, as noted by Considering that the atmosphere is an open- ternalities have a positive unintended effect on Common and Stagl (2004), access resource and not a pure private good, other agents, negative externalities have a nega- the expression “tragedy of the commons” – introduced economic theory tells us that it cannot be effi- tive unintended effect on others. Vaccinations in a famous article by Garrett ciently exploited by a market economy. If market are examples of positive externalities. They pro- Hardin in 1968 – is mislea- economies exploit open-access resources such as tect the vaccinated person as intended, but also ding because the problem is the atmosphere, they tend to overuse these re- have a positive unintended external effect, low- not related to common pro- sources. The resulting market failure then leads ering the probability that other non-vaccinated perty rights, but to the open access to the common pro- to outcomes that are not socially optimal. The persons catch the disease. GHG emissions are a perty. Thus, as Common and main reason for this overuse is the open access to typical example of negative externalities. While Stagl suggest, the tragedy the resource. As no individual or group is able to they are the by-product of an intended produc- should have been labeled “the control who is dumping greenhouse gases into tion process, they have a negative unintended ef- open-access tragedy.” the atmosphere, economic actors adopt a “use it fect on others by contributing to climate change. 50 Note that there are various or lose it” mentality and use the GHG repository ways to classify externa- function of the atmosphere on a “first come, first Markets fail in the presence of externalities be- lities. Besides classifying externalities into positive and serve” basis, thereby collectively overusing the re- cause agents do not take these effects into ac- negative, one can also classify source (Tietenberg and Lewis, 2012) by dumping count when making their decisions. The reason them by the economic acti- massive amounts of greenhouse gases into the why they do not take them into account is that, vity in which they originate atmosphere. This problem is widely known as the by definition, these effects are unintended and (production or consumption) “tragedy of the commons,”49 and is at the heart hence, there is no monetary reward or penalty to and by the economic activity that they affect (production of economists’ explanation of the occurrence of the agent generating the externality. Thus, in the or consumption). See Perman climate change. case of positive externalities, generating the pos- et al. (2011) for an overview itive effect, in itself, is not sufficiently encouraged on classifications of different As we will see in Section 3.2, the overuse induced as there is no reward for doing so. In the case of externalities. by the open-access problem is made worse by negative externalities the opposite happens: as what economists call negative externalities: eco- there is no monetary punishment for generating
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module 53 52 The economics of climate change (SMB). benefits perceived bysociety (PMB) the marginal and benefits perceived byafirm the marginal wedge between externalities woulddrive a Stagl (2004: 327–29). inCommondiscussion and externality closelyfollows the of anegative production 51 future generations. to or the planet viduals on to otherindi- either accrue these costs of the bulk but the costs ofclimatechange, bearssomeof the firm that followingThe example To beprecise, ispossible it Consumption-based 70 n bnft it acut inrn theaddi- ignoring account, into benefits and costs personal their take only agents economic emissions,GHG involving decision consumption erations. Thus, when making a production and/or by all people across the planet, and by future gen- rather but gases, greenhouse emits production whose goods or of firms consumers emitting the by borne not are generations.costs future These and thus indirectly imposes costs on present and greenhouse gases into the of atmosphere causes climate quantitieschange large Emitting ties). - activi other of variety wide very a through and cattle, raising by energy, produce to fuels fossil products of production processes (e.g. by burning by- as gases greenhouseproduce beings Human the caseofGHGemissions.happens in what exactly is this see, will we As effect. ternal ex negative the exacerbating thereby ternality, ex negative the of much too produce markets Consequently, them. generating from couraged dis- sufficiently not are agents effects, negative firm’s firm’s the with PMCs the willequate the manager profits, firm’s the much the firm will produce. In order to maximize how decide to firm’s managers the by used are also costs These output. production total its of unit last the producing for incurs firm the costs the speaking, loosely indicates, curve This costs. labeled PMC curve second a displays also 32 Figure Source: Author'selaboration basedonCommon andStagl(2004: 327). as this is the only point where point only the is this as the quantity produce will firm the Thus, curve). demand the efficient and thus not optimal from society’sfrom ofview.point optimal the case? this Why is not thus and efficient Pareto- not is allocation this that is problem The Figure 32 , which stands for the firm’s private marginal Price P P SO M Q M , the selling price each at unit Greenhouse gas emissions: PMB s (representeds by PMC equals Anegative problem production externality Q PMB SO P M - - . , = as the external marginal cost and is given by marginal cost and private marginal cost is known al costs (PMC ( good the producing of costs Therefore,marginal social account.the into taken be to have that good the productionof the with costs associated additional are society,these the of view of point involving greenhouse gases. decisions production of case the of illustration this, Figurefor 32 clarify graphicalat a look us let optimal.Tosocially is what than more emit they tional costs they impose on others. Consequently, benefits equal social marginal benefits (SMB). marginal private consumption- thus and externalities, no related are there that here assume produced.charge per unit For simplicity, we shall sponds, loosely speaking, to the price the firm can fits (PMB). A firm’sprivate marginal benefitcorre - representsalsofirm’s the private bene- marginal buy.to want curve people demand the that Note good the of more the price, the lower the usual, As good. the for demand consumers’represents curve demand The good. the of price the axis y The x axis displays the quantity produced and the emits that process.production its during gases greenhouse firm specific a of view of point the Figure 32 displays a market for a given good from of climate change) are, however, not borne by by the firm, the society. the of by rest but borne not however, are, change) climate of (i.e.costs greenhousegases the emitting with ed contributes to climate thus change. The costs and associat process production the during gases greenhouse earlier, emits mentioned firm As the SMC SMC s) arethe than firm’shigher private margin- - PMC Q M SMC . In our example, the external margin- s). The difference the between social Demand (=PMB=SMB) 51 PMC Quantity 53 From the EMC 52 -
The economics of climate change 3 al costs correspond to the climate change-related ample can be generalized and extended to also costs occurring as a result of greenhouse gases include negative consumption externalities, such module emitted during the production of the good. The as the pollution created by using cars. Pareto-efficient point of production would thus not be the production level the firm chooses, In conclusion, as GHG emissions are negative ex- but the pair QSO and PSO, where social marginal ternalities and the atmosphere can be used as benefits equal social marginal costs. We thus see an open-access resource to dump them, markets in Figure 32 that the firm produces too much of fail to achieve Pareto-optimal situations. Instead the good (QM instead of QSO) and sells the good of optimally allocating resources, market econo- at a price that is too low (PM instead of PSO) be- mies dump unprecedented quantities of GHG cause it ignores the climate change-related costs emissions into the planet’s atmosphere, and are it imposes on others. The existence of the nega- thereby changing the climate of the earth. This tive production externality therefore leads to a massive market failure represents a danger for market failure due to which the firm emits too present and future generations and as such has much greenhouse gases into the atmosphere been identified by Stern (2007) as the biggest compared to a Pareto-efficient situation. This ex- market failure in the history of humankind.
Short summary Sections 2 and 3 showed that while markets theoretically achieve Pareto-efficient outcomes, they fail to do so if some conditions are not satisfied. The occurrence of climate change is an example of such a failure, identi- fied by some influential authors as the biggest market failure in human history. As shown in Section 3, this failure has two causes. First, the atmosphere’s function as a GHG repository is an open-access resource and is therefore overused by economic actors because, unlike pure private goods, open-access resources cannot be efficiently dealt with by market economies. Second, greenhouse gas emissions are negative externalities. Economic actors do not directly bear the climate change-related costs associated with the emissions that they can dump free of charge into the atmosphere; consequently, they emit too much greenhouse gases. Together, these two reasons explain why markets fail and, hence, why climate change occurs.
4 Why is it so hard to solve the climate tion 4 will show how economic theory explains change problem? the fact that the international community has been struggling for decades to solve the climate As shown in Section 3, climate change occurs change problem despite the fact that the appar- because markets fail and do not achieve Pareto- ently simple solution has long been known. As optimal allocations. As we have seen, rational we will see, much of the problem is related to the economic agents, pursuing their own self-inter- fact that solving global environmental problems est in an uncoordinated way, overexploit the at- like climate change requires cooperation among mosphere’s GHG repository function and ignore countries, which is not necessarily easy to achieve. the costs they impose on others. Consequently, they emit too much greenhouse gases into the 4.1 Mitigating climate change: A global atmosphere and cause climate change. There- public good fore, to solve the problem one cannot simply rely on a market system, as it is precisely this system Mitigating climate changes requires reducing that fails and which is at the root of the problem. anthropogenic GHG emissions (IPCC, 2014b). Economists conceptualize climate change miti- Climate change can only be fixed by a policy in- gation as a good that can be supplied and con- tervention that corrects the market failure. A pri- sumed. To supply the good, efforts have to be ori, the solution is simple: if humans emitted less taken to reduce GHG emissions. Consumption greenhouse gas into the atmosphere, they could of the good is passive: everybody can reap the stop or at least considerably slow climate change. benefits of climate change mitigation by living If each country’s politicians decided to cut GHG in a world that is not affected by the potentially emissions, climate change could be mitigated or catastrophic effects of a changing climate (IPCC, even avoided altogether. Thus, where is the prob- 2014a). However, climate change mitigation is not lem? Why is humankind still struggling to imple- a “normal” good, i.e. it is not a pure private good ment this solution on a global scale? Since Man- like most of the commodities we consume in our cur Olson’s now-famous work in 1965, The Logic of daily lives.54 From an economist’s point of view, 54 See Section 3.1 for a defini- Collective Action, economists have been working climate change mitigation is a so-called global tion of pure private goods. on a theory to explain this puzzling situation. Sec- public good (Ferroni et al., 2002; IPCC, 2001; Per-
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module 55 56 The economics of climate change 28 of Varian (2010). drawsthis section onChapter in theory notions ofgame on game theory.on game provides additional readings change mitigation. Annex1 for the analysis ofclimate concepts andnotionsneeded only coversthe essential Note that this short review this short that Note presentationThe ofbasic 72 privategoods. Policymakers thereforein- to need deal type they of cannot with good non- because this supply efficiently cannot markets 3, Section in shown As challenge. a is mitigation change climate as such goods public global Supplying Perman al., et 2011; Sandler, 2004). gation a gation “globalgood”public (Ferroni miti- change climate labelled has literature the globe, the on countries all by consumed be can GHGreduction a country’s of benefits the that Moreover,goods. public pure given be to con - sidered are reductions GHG non-excludable, and non-rival both are benefits the benefits. As these enjoying nations other of possibility the affect not does reductions GHG of benefits the suming other con- Thus,reduction. this from benefits obtain countries the slightest the in reduce not does emissions GHG its reducing from obtains a country benefit The non-rival. also are gation miti- change climate of benefits the Moreover, thereforearemitigation non-excludable.change climate of benefits itself. The to only reductions GHG its of benefits the limit to impossible is it emissions, its cuts that country the For duction. re- a such from gain countries all scenario. Thus climate change compared to a business-as-usual slows thereby and atmosphere the in centration con- GHG global the lowers directly emissions country’sGHG a Cutting worldwide. humans all to available instantly are benefits emissions,the GHG its reduce to decides country a If good. lic pub- a be to considered thus is and properties Climate change mitigation has exactly these two unit. in qualitythat orquantity of degradation any without individuals of number any by consumed be can good public a of unit a magic, like that, stating magic, to goods public global of property this compares (2004) Sandler unit.same the groupindividualor er consuming anoth- of possibility affectingthe groupwithout consumedbe individualcan an good by the or of unit particular a that rybody.means Non-rivalry plied, their benefits are instantly available to eve- good,the consuming arei.e.sup- goods the once fromexcluded be can nobody that means ability non-exclud- explained, we As benefits. non-rival and non-excludable having those as them fined de- and goods public introducedpure 3.1 Section several areto overcome. hard problemsthat and involves is difficult quantities sufficient in goods public global follow,supplying that tions sec- the in see will we problem.As change mate cli- the solve to community international the of the at of heart economists’ explanation for the inability is mitigation change climate of nature man , 2011; Sandler, 2004). The public-good The Sandler,2004). 2011; al., et et al., et 2002; game 4.2 Basic to mitigateclimatechange. trying tries ed the with strategic interactions between coun- associat problems the analysing systematically for allows that theory,tool theoreticalgame a of introduces Section 4.2 basic theoretical elements ing itsemissions. reduc- be actually will country no day the of end the at that possible quite is it reasoning, same calls “free-riding.”the makecountrycan every As literature the that behaviour a is result. This the from benefits, benefit the receiving from cluded ex be cannot they then,as and good the supply to countries other for wait just might countries emissions,GHG reducing by good the supplying plication for the supply of such a good: instead of climate change mitigation has a devastating im- of non-excludability show,the will (Sandler,we As 2004). change cannot country single a that outcome inefficient an in result countries vidual indi- by decisions rational when occur that ures fail- action collective in result often problems of problem” action lective (Sandler, 2004). type This a called is “col what goods - public (global) plying thereof lack – of other countries. This makes sup- that country’s actions, but also on the actions – or on depend only not do country one for benefits and costs the that fact the from come goods lic pub- global supplying with associated problems the of see,many will we change.As climate miti- gate to order in collaborate to need therefore Countries 2001). (IPCC, change climate mitigate and atmosphere world’s the change of composition the itself by can country single no as lem, prob - the solve single-handedly can country No goods. public global supply to struggle nations also But failure. market this correct and tervene strategic interactions amongcountries. analysing for allow that concepts and notions theory game basic introduce will we mitigation, the analysis of climate change fore with we start mitigation.problemschange climate as such Be- action collective in involved issues the analyse to useful particularly is it behaviour, economic and negotiations political study to used Widely 2010). among (Varian, countries interaction or groups, strategic individuals, of form any ing study for allows that apparatus theoretical a is important concepts like free-riding. Game theory differentgrasp and stake at problem the of ture na- the understand to readers enable will tools these Using tools. theory game basic introduce lic good of climate change mitigation, we have to globalthe pub- whysupply to countries struggle words, other in or emissions, GHG their reduce In orderto understand why countries to struggle notionsandconceptstheory 56 55 - - - The economics of climate change 3 Strategic interactions involve at least two indi- Suppose you have two players (player A and player viduals or groups called “players.” A priori, any B) playing a game. Each player has a sheet of paper module strategic interaction can involve many players and has to write one out of two words on his or and each player can have a large set of different her sheet. Player A can either write “Top” or “Bot- strategies. An example of a strategic interac- tom.” Simultaneously, player B can choose to write tion would be climate change mitigation nego- “Left” or “Right.” Player A does not see what player tiations among different countries (the players), B is writing and vice versa. Each player will obtain a with each country pursuing its own strategy. A payoff that depends not only on his or her actions, country’s strategy could be, for instance, to re- but also on the actions of the other player. And each duce GHG emissions or to not reduce GHG emis- player has been informed about the potential pay- sions. A formal representation of such strategic offs he or she could get before playing the game. In interactions is called a “game.” Games are the the game theory terminology, the players’ options game theorist’s tool to formally capture situa- to play the game are called “strategies.” Thus in tions in which individuals or groups interact in this game, each player has two strategies: player a context where their welfare not only depends A’s strategies are “Top” and “Bottom,” and player B’s on their own actions, but also on the actions of strategies are “Left” and “Right”.57 After both play- 57 Actually, this is not com- others (Mas-Colell et al., 1995). To introduce the ers have written down their word, the sheets of pletely accurate. Formally, basic game theory notions and concepts we limit paper are examined and the players receive their strategies are defined to be a “complete contingent ourselves for now to strategic interactions with payoffs. These payoffs are listed in a payoff matrix. plan, or decision rule, that only two players. This kind of game can be repre- The payoff matrix of this simple game is displayed specifies how the player sented in what is called a “payoff matrix.” To illus- in Figure 33. It shows the payoffs to each player for will act in every possible trate how to represent a game in a payoff matrix, each combination of strategies, and it is known to distinguishable circumstance we use an example by Varian (2011: 522). each player before they start to play the game. in which she might be called upon to move” (Mas-Colell et al., 1995: 228). However, as Figure 33 the game we are currently Payoff matrix of a two-player game with a dominant strategy equilibrium looking at consists of only one move (writing down the word) and the players Player B have to write down the word simultaneously, and because we exclude the possibility of Left Right mixed strategies, the choices “Top” and “Bottom” are the two strategies of player A, Top 2,3 1,2 while the choices “Left” or “Right” are the two strategies Player A of player B. Bottom 4,2 2,1
Source: Author's elaboration based on Varian (2010: 523).
As an example, if player A plays the strategy “Top” ing payoffs of playing “Top” (2 and 1). Player B has and player B plays the strategy “Right,” we ex- a strong incentive to always play “Left,” as the amine the upper right field of the payoff matrix payoffs from playing “Left” (3 and 2) are always that contains the payoffs for this combination of higher than the corresponding payoffs of playing strategies. If the players play in this way, player “Right” (2 and 1). Thus, we expect that in equilibri- A will receive a payoff of 1 (the first entry in the um we end up in the lower left box of the matrix, upper right box), while player B will receive a pay- as player A will always play “Bottom” and player B off of 2 (the second entry in the upper right box). will always play “Left.” Similarly, if player A plays “Bottom” and player B plays “Left,” we see in the lower left box of the We have been able to quickly find the solution matrix that player A will receive a payoff of 4 to this game because each player has what is 58 Note that this kind of while player B receives a payoff of 2. called a “dominant strategy,” which is a player’s strategy is called “strictly best strategy regardless of what the other player dominant” as opposed to 58 “weakly dominant,” but for Having understood how one reads a payoff ma- plays (Mas-Colell et al., 1995). Here, player A’s the sake of simplicity we will trix, we can now ask ourselves what happens if “Bottom” strategy dominates his or her “Top” not discuss this difference these two players actually play this game. Player strategy, as the player will get a higher payoff as it is not needed to A has a strong incentive to always play “Bottom,” playing “Bottom” no matter what player B choos- understand our main point. because the payoffs from playing “Bottom” (4 and es. On the other hand, player B’s dominant strat- For more information see the additional readings listed in 2) are always higher compared to the correspond- egy is playing “Left” because no matter what Annex 1.
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module 61 60 59 The economics of climate change equilibrium in this game in equilibrium ”Right” isasecond Nash reasoning, similar “Bottom”/ change mitigation. to analyse climate them need material aswe donot teaching strategiesthis in discuss mixed further not will topic).this on discussion We in Mas-Colell al., et 1995, for a very popular(seeChapter8 games, the concept making for a fairly broad range of exist Nashequilibria that into account, onecanshow takesone mixed strategies assigned (Varian, 2010). If the probabilitiesaccording to the choices choices andplay their probabilitiesto each of strategiesthey assign When players play mixed or “randomized strategies.” speak of “mixed strategies” they doso, theorists game randomizetheir choices. If probability, players canalso option with100percent this an optionandplaying for all. Insteadofchoosing choosing anoptiononceand sofar at of andwhichconsist the oneswehaveare looked strategies.” Pure strategies considers onlyso-called “pure ifone a Nashequilibrium have not some gamesmight Another problemthat is the gameinFigure 34. by equilibrium, asillustrated than one Nash has more agame that ispossible it that movie “A BeautifulMind.” Howard’s 2001biographical Nash was popularized inRon One of the problems Oneof is workof theory game The Asyou canverify, using 74
Source: Author'selaboration basedon Varian (2010:524). is revealed, neither individual wants to change his person’s choice other the when that, such choice person’seach about expectations of as pair “aed be.will thus A be Nash can interpretequilibrium choice player’s other the what about idea some they make their move, but each player might have before play will player other the what knows ers equilibrium. er B can choose is “Left.” Thus, “Top”/”Left” is a Nash time, if player A plays “Top,” the best strategy play gy player A can choose is to play “Top.” At the same equilibrium: if player B plays Nash “Left,” a the best strate- such be “Top”/”Left” would 34, Figure In strategy equilibrium. dominant a is equilibrium Nash each not but equilibrium,Nash a also is strategy equilibrium dominant each equilibria: strategy dominant than concepts solution weaker are equilibria Nash sense, that player.In other the by played er can choose, given the strategy that is actually strategy choice is the best strategy that the play other words, in a Nash equilibrium, each player’s In 2010).(Varian, player other optimal the of given strategies optimal be strategy player’s a player,other that requiresthe only concept this of choices possible all for optimal be strategy often. Let us look at a game with the same rules rules same the with game a at look us often. Let happen not do but find, to simple are equilibria strategy dominant out, points (2010) Varian As equilibrium.” strategy “dominant a called therefore is rium - equilib resulting “Right.”plays The she or he if payoffhigher a get will she or plays,he A player laureate. Prize Nobel John and economist American by an Nash, 1951 in introduced was equilibrium, Nash the concepts,called these of One actions. inter strategic analysing for allow that cepts con- alternative developed therefore theorists fre- quently have do not dominant strategies. Game players interactions, strategic real-life In Figure 34 59 59 nta o rqiig ht player’s a that requiring of Instead 60 Of course, neither of the two play two the course,of Of neither Player A Payoff ofa matrix Bottom Top two-player game with - - - - - global publicgoodofclimatechangemitigation. the supply to trying countries among teraction we use game theory tools to model a strategic in- change. climate Toso mitigate do to community international the of failure decade-long the of analysis the towardsattention our turn Wenow perspective change mitigation: 4.3 Climate climate change sofar. mitigate to community the international of failure the for reasons the highlighting and wrong goes interaction, what tegic showing strathis - introducedabove,analyse tools will we theory game the change.Using climate mitigate dinated effort bydifferent countriesto isneeded coor countries,a among interactionas strategic a involves mitigation change Climate problem. change climate global the solve and emissions to analyse why countries to struggle reduce GHG theory,of game tools wenowhave the necessary concepts and notions basic the covered Having to analyse strategic interactions. has severalproblems,has equilibrium Nash the of concept the While lose. only could player opportunity,the the as had she or he if strategy her or his change unilaterally to From this Nash equilibrium no player would want “Top”/”Left.” equilibrium Nash the in ends game the and “Left”choose will B “Top,”choose player to A player expects B player if “Top,”choose and will A player “Left,”choose to B player expects A behavior” (Varian, 2010: 525). For instance, if player fore also strategy nodominant equilibrium. (or for player A, as you can easily verify) and there- B player for strategy dominant no is there Thus choose “Right.”to wants B player “Bottom,”then chooses A player if “Left,”choose but to wants B player “Top,”chooses then A player If strategies. ure 34. As one can see, this game has no dominant Fig- in displayed different structure payoffa but Left 0,0 4,2 two Nashequilibria Player B 61 it is a very useful concept concept useful very a is it Right 0,0 2,4 Agame theory - The economics of climate change 3 4.3.1 Climate change mitigation in a world of the atmosphere alone and mitigate climate composed of two countries change single-handedly (IPCC, 2001). The benefits module of a single country reducing GHG emissions will We start our investigation of this strategic in- therefore be relatively small compared to the teraction by making a simplifying assumption. costs the country incurs in doing so. Hence, the We suppose that the world is composed of two cost of financing the GHG reduction for a single identical countries that try to mitigate climate country (12) has been chosen to be bigger than change: country A and country B. Each individual the benefit (10) the country obtains from single- country can play two strategies: it can choose to handedly reducing its emissions. either reduce its GHG emissions by 20 per cent, or not to reduce its GHG emissions at all. As mentioned in Section 4.1, climate change mitigation is a global public good, meaning that If the country chooses not to reduce its emis- the benefits of abating are non-rival and non- 62 In game theory, this sions, it does not bear any costs but also does excludable. This implies that if country A chooses game structure is called a not receive any benefit. If the country chooses to to abate – paying the cost of 12 and receiving the “prisoner’s dilemma” and is probably the best-known reduce its emissions, it has to pay a cost of 12 in benefit of 10 – country B also receives a benefit application of game theory. order to finance the GHG reduction. At the same of 10 without doing anything whatsoever. This is This game was introduced time, the emission reduction yields a benefit of a crucial point one has to understand. Country B by Merrill Flood and Melvin 10 for the country, as it reduces the negative ef- receives a benefit from the emission reductions Dresher in 1952. Albert Tucker fects of climate change. While these cost and made by country A, because country A’s emission used a fictive interaction between two prisoners as an benefit numbers have been chosen arbitrar- reductions lower global concentrations of atmos- illustrating anecdote, which ily, they reflect an important property of climate pheric emissions. Country A’s efforts thereby slow gave the game its name change mitigation. As the climate is the product climate change, which positively affects country (Poundstone, 1992). Varian of the behaviour of all nations on the planet, A and country B. This leads to the payoff matrix (2010: 527) outlines Tucker’s no single country can change the composition displayed in Figure 35.62 original story as follows: “[T]wo prisoners who were partners in a crime were Figure 35 being questioned in separate Reducing greenhouse gas emissions in a world composed of two countries rooms. Each prisoner had a choice of confessing to the crime, and thereby implica- Country B ting the other, or denying that he had participated in the crime. If only one prisoner Not reduce Reduce confessed, then he would go free, and the authorities would throw the book at Not reduce 0,0 10,-2 the other prisoner, requiring him to spend 6 months in Country A prison. If both prisoners Reduce -2,10 8,8 denied being involved, then both would be held for 1 month on a technicality, and Source: Author. if both prisoners confessed they would both be held for As can be seen in Figure 35, if both countries de- Clearly, from the point of view of the whole plan- 3 months.” This game has a cide not to reduce their emissions, nothing will et, the best outcome of the game would be that similar payoff matrix as in happen: country A and country B both obtain a both countries reduce their emissions and there- Figure 35, leading both ratio- payoff of 0 as there are neither mitigation costs by contribute to mitigating climate change. This nal prisoners to confess, while they would have been better nor mitigation benefits associated with inaction. would yield an overall benefit of 16 (8+8), which is off denying the crime. If country A decides to reduce its emissions while the highest possible payoff for the whole planet country B decides not to reduce, country A ob- in the game.63 Thus, “Reduce”/”Reduce” is a so- 63 The other options yield tains a payoff of -2 (the benefits it produces (10) called “social optimum.” But in this game, the so- planetary payoffs of 0 minus its costs of doing so (12)) while country B cial optimum is not the likely outcome. Or stated (0+0), 8 (-2+10), and 8 (10-2), respectively. receives a payoff of 10. Similarly, if country B de- differently, “Reduce”/”Reduce” is not a Nash equi- cides to reduce while country A decides not to re- librium because the best choice country A could duce, country B receives a payoff of -2 and country make given that country B reduces its emissions A receives a payoff of 10. Finally, if both countries is not to reduce its emissions. In that case, coun- decide to reduce, each country obtains a payoff try A would receive a payoff of 10, which is greater of 8 (country A receives the benefit produced by than the payoff of 8 the country would obtain itself (10) plus the benefit produced by country by also reducing its emissions. The exact same B (10) and pays its reduction costs (12); the same reasoning applies for country B. This free-riding goes for country B). behaviour is the main problem associated with
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module 64 The economics of climate change et al.(2011).et (2004)andPermanin Sandler country prisoner’s dilemma the presentation the n of draws section This on 76 nta o cnrbtn t mtgtn climate mitigating to contributing of Instead position”18).(Sandler, inferior2004: an in left is ality may make choices from the which collective ration- of tenets the by abide who countries] [or rationality.collectivefor cient is, That individuals action failures: collective “individual rationality is not suffi- all underlying problem the lustrates - il perfectly it simple, very is game the Although thereby mitigateclimatechange.emissions and their reduce to decided simultaneously countries the whole planet would clearly be better off if both sions, as both prefer to free-ride. At the same time, thus predicts that no country will reduce its emis- would obtain a payoff of -2 instead of 0. The game it equilibrium, Nash the in choice its alter erally opportunity.the givenunilat to countrywere a If if unilaterally choice its alter to incentive an has B country nor A country neither equilibrium, this At game. the of equilibrium Nash the also time same the at and equilibrium strategy dominant emissions. Hence “Not reduce”/”Not reduce” is the its reduce not does it if payoff higher a obtains B country A, country of choices both for B: country for true holds same B. The country of choice the matter reducing,no not by off better be will A try emissions:coun- its reduce to not is game this in A’scountry strategy that dominant see easily can One game? the of outcome likely the is what So byitself. doinganything tions without ac- these from benefits and action take country if the country free-rides, that is, if it lets the other could hope countryfor in the whole game (10) is obtained a payoff best the Actually, mitigation. the provision of public goods like climate change Source: Author'selaboration basedonFigure (2004)and 2.2inSandler Table 9.1inPerman al.(2011). et payoff is 0.the Nash equilibrium in planetary aggregated the action, take to centive duces its emissions. Given that nobody has an in- re- nobody that is game the of equilibrium Nash the same holds for all other countries, the unique contribute.countriesAs other many how matter exceed the payoffs in the bottom row by row bottom the payoffsin the exceed row upper the in payoffs the because free-ride country emissions, their reducecountries n-1 if see,even can one As per cent emissions by20 reduce GHG not Country idoes 20 percent emissions by reduce GHG Country idoes Table 5 s oiat taey s to is strategy dominant i’s greenhouseReducing gas emissionsinaworld ofncountries b 0 0 i -c i Number of greenhouse-gas-reducing countries other than country i country than other countries greenhouse-gas-reducing of Number 2b b c 1 i -c i i -b i i ,no - emissions, leading to a maximized planetary planetary of n maximized payoff a to leading emissions, their limit countries all when occurs game the of outcome optimal socially The outcome. timal op- socially a not clearly is equilibrium Nash The b duces its emissions, country payoffs rider for country i other i i try payoffs of this game from the perspective of coun - each of the other the of each contributes, country ireceives 2b c reducing its GHG emissions by 20 per cent equals countrygiven fora that further pose emissions.GHG reduce Sup- to not or cent per 20 tween two strategies: to reduce GHG emissions by n of total a of consists planet Tothe so,do suppose incorporate any numberofcountries. to problem action collective the generalize and the in world, we relaxthis restrictive assumption countries two than more considerably are there that Given countries. two of composed world a So far we have analysed a strategic interaction in the free-rider payoffs are higher for all countries all for higher payoffsare free-rider the composed ofncountries 4.3.2 Climate change mitigation inaworld change bemitigated.thus not will climate free-ride; to incentives strong have countries emissions, reducing by change try try contributes,coun- country other no if emissions: country for payoffs the )b (n-1 obtain will it because free-ride to incentive an has always i other allEven if solution.stable a not is optimum social this that country able benefit of benefit able the country produces a non-rival and non-exclud- while the columns indicate the actions of the the of actions the indicate columns the while i i . By reducing its greenhouse gases by 20 per cent, identical countries. Each country can choose be- , if two other countries reduce their emissions, their reduce countries other two if , i . The rows show the two strategies of country strategiesof two .the rowsshow The obtains a payoff of payoff a obtains 3b 2b countries. free-n-1 the rowdisplays top The 2 i -c i i i obtains 2 b i -nc b i countriescontribute, n-1 country
i i (whereas . Again, we want to emphasize to want we Again, . , which is greater than greater is ,which 2b nations. the Tablen-1 displays 5 i , etc. The bottom row shows row bottom etc., The (…) (…) (…) i b when it does reduce its its reduce does it when :countryother one reif - i -c c i i , if one other country other one if , >b i receives of a benefit i 64 ), benefiting it and ), and it benefiting i -c
i , etc. i , the cost of of ,cost the (n-1)b nb n-1 nb i -c i i i -c i .As The economics of climate change 3 no matter how many other countries contribute, tion efforts. Mitigation costs and opportunities the world ends up in the unique Nash equilib- also differ between countries. Finally, there is the module rium with nobody reducing its emissions.65 issue of international and intergenerational jus- 65 To illustrate these results tice affecting negotiations about the financing with numbers, assume that Hence, the modified game structure does not of climate change mitigation (see the discussion the costs and benefits are the same as in the two-country result in a different prediction. Even in a world on the principle of common but differentiated example (ci = 12 and bi = 10) composed of many countries, rational countries responsibilities in Module 4). All these factors and assume further that the would still free-ride and not contribute to miti- further complicate the collective action problem world is composed of the gating climate change. While the game theory and influence the likely outcome (or prognoses) 194 United Nations member approach reveals the essential nature of the of strategic interactions.66 countries (n = 194). Then, the planetary payoff in the problem (free-riding), things are even more com- social optimum would equal plicated in reality. Countries are not identical as In addition to factors related to the global public 1942*10-194*12=374,032, we assumed in the games above: they vary in good nature of climate change mitigation and with each individual terms of size, wealth and technology. Costs and their game theory implications, there are other country obtaining a payoff benefits of mitigation also differ widely among factors that can influence the outcome of collec- of 194*10-12=1,928. But the socially optimal outcome is countries and are only imperfectly known (Com- tive action. Box 14 illustrates this issue by show- not an equilibrium, because mon and Stagl, 2004; Perman et al., 2011; Sandler, ing the vastly different outcomes of two, at first nation i (and thus also all 2004; Stern, 2007). Countries are not equally af- sight similar, collective action problems – mitiga- other nations) would have fected by the consequences of climate change, tion of ozone-shield depletion and mitigation of an incentive to free-ride (the thus they would not equally benefit from mitiga- climate change. country’s payoff would be greater if it free-rides and all the other n-1 countries contri- Box 14 bute: (194-1)*10=1,930>1,928). Different collective action outcomes for identical collective action problems Thus the world ends up in Sandler (2004) highlights that seemingly identical collective action problems like the provision of a global the unique Nash equilibrium public good can have vastly different collective action outcomes. To illustrate his point, he compares the col- with a planetary payoff of 0, which is clearly less than the lective action outcome of two pollution problems. One the one hand, the international community has been social optimum. rather efficient in mitigating stratospheric ozone shield depletion caused by chlorofluorocarbons (CFCs) and bromide-based substances. On the other hand, it is still struggling with mitigating climate change caused by 66 More complicated game the accumulation of greenhouse gases in the atmosphere. Mitigating CFCs and mitigating greenhouse gases structures can incorporate some of these additional are both global public goods. Moreover, both problems are pollution problems and their solution requires factors. See Annex 1 for international cooperation to reduce emissions. In the CFC case, humankind succeeded, while efforts to reduce additional reading material GHG emissions have not been successful to date. Sandler explains this difference in the outcomes of collec- on this issue. tive action by the differences listed in Table 6. All these factors make finding a collective action solution more difficult in the case of climate change as compared to ozone-shield depletion.
Table 6 Factors affecting outcomes of collective actions Ozone-shield depletion Climate change
Emissions concentrated in relatively few countries Emissions are added by virtually every country
Every country loses from a thinning ozone layer There are winners and losers from global warming There are substantial commercial gains from CFC substi- Uncertainty about substantial commercial gains from GHG tutes substitutes Uncertainty in terms of process and consequences has Uncertainty remains in terms of process and consequences been resolved Dominant strategy for some key polluters is to curb emis- Dominant strategy for most key polluters is not to curb
sions, since bi-ci>0 pollutants, since bi-ci<0 Leadership by key polluters Lack of leadership by key polluters
Intertemporal reversibility within 50 years No intertemporal reversibility within 50 years Decision makers were more informed about benefits than Decision makers were more informed about costs than costs benefits Relatively few economic activities add to ozone-shield Many economic activities add to global warming depletion
Source: Table 10.4 in Sandler (2004), updated by the author.
Consequently, as Sandler (2004: 213) states, “the contrast between global collective action and inaction hinges on factors that go beyond the non-rivalry and non-excludability of these global public good’s benefits…. Knowl- edge of just the properties of a public good is not always sufficient to provide a prognosis for collective action.”
Source: Author's elaboration based on Sandler (2004)
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module good problem (Sandler, 2004). system isitselfapure public 68 67 The economics of climate change et al.et (2011) for anoverview. Putting in place a penalty Puttinginplaceapenalty SeeChapter9.3inPerman 78 acting acting ,(0-p whereas ties.theory,In than any penalty larger containpenaloff,- to need would agreement the pay its maximize to free-ride subsequently and treaty a such to on sign strongto incentivea has reduce their emissions. However, as each country all they that agree to have would countries The 2012). Lewis, and Tietenberg 2004;Sandler, 2011; Perman 2004; Stagl, and (Common tries a binding international agreement between coun- through reached be could outcome an Such mal situation. opti- socially a to automatically positive leading payoff, the of because single-handedly sions emis- reduce to incentiveshave would countries incentive-compatible:individual be would mum opti- social the positive, were alone acting from payoffsdifferently, the Stated optimum.if social the to corresponds equilibrium Nash the where situation a to lead would emissions. This reduce country would have an incentive to act alone and each positive, were they If matter. alone acting outcome might be changed. Clearly, payoffs from game this how insightson providesalso certain theory outcome, this explaining to addition In failure.collective action massive a in results emissions. This their reduce not and free-ride to incentives strong have thus countries behaving Rationally emissions. their than the payoff they would obtain from reducing payoff countries obtain from free-riding is higher the change, climate mitigating of nature good public between global the to due that, interaction showed countries strategic the modelling games two question. The this to answer oretical time. Sections 4.1, and provided4.3.1 4.3.2 the the- long a for known been has solution simple ently climate change problem, even though the appar the solve to fordecades struggling been has nity commu - international the that fact the explains Section 4 by started asking how economic theory models theory game 4.3.3 Climate change mitigation: Lessons from alty system is not straightforward, history not the is as system alty pen- a such optimum.However,place in putting Nash equilibrium would correspond to the social alone (b job.the do penalty,this With payoff the acting of i -c i ) would be larger than the payoff of not p>c i -b i is the penalty) and the c i -b i would t al., et - - ehnss o noc cooperation. enforce to mechanisms alternative of number a suggests theory game Besides self-enforcing international agreements, countries (Finus,participating 2003). importantly,enforcedbe treatythe can the by (c) treaty,the of and, design most the on consensus countries,all participating reachthe parties a (b) for benefits net positive yield treaty the (a) that requires cooperation effective that show ments agree - environmental international of Reviews 1994). (Barret, needed most is cooperation the when and high are stakes the when achieve to hardest seems cooperation effective illustrates, mitigation change climate as Moreover, large. is countries affected of number the when little achieve anyway,and take to intended countries actions codify largely to efficiency: seem treaties their regarding views pessimistic rather offers consequently agreements environmental tional Perman a self-enforcingway. in literaturetheoretical(see The designed be thus should and countries of actions voluntary on rely therefore agreements environmental International level. global the on exists enforcer such no states,sovereign of sists contoday’s- al. ,world 2011).As et (Perman pay to countries force to power the with party third a could only be forced to pay penalties if there were enforcement of such a penalty system. Countries oue 4). Module (see shown has negotiations change climate of ule 4, the Paris Agreement has been partially partially these mechanisms. on built been has Agreement Paris the 4, ule different options emerge. As will be seen in Mod- of variety a communicate, countries if and zon, - hori time undefined an over repeatedly played is game same the If once. only played games” “one-shot are above introduced we games two The are repeated. are games cooperation when pessimistic for less prospects the that cates indi- Moreover, theory game. the of nature the change thus and countries for payoffs the alter might issues, policy change climate and ment tions,those achieved such as by linking develop- reduc- emission of co-benefits the Furthermore, countries. cooperating of number the increase are could countries payments side other Transfersdoing.and other what of regardless emis- sions reduce to commitments credible make to able are countries if fostered be can eration et al.,et 2011, for review) a on short interna- 67 At least equally difficult would be would difficult equally least At 68 Coop- The economics of climate change
Short summary 3 How does economic theory explain why the international community has been struggling for decades to solve the climate change problem, even though the apparently simple solution has been known for a long module time? To answer this question, Section 4 showed that climate change mitigation is a global public good with non-rival and non-excludable benefits. As no country is able to change the composition of the atmosphere single-handedly, international cooperation is needed. The section introduced game theory concepts that were subsequently used to analyse the strategic interaction between countries. Two games illustrated the main cause of the collective action failure: that countries have strong incentives to free-ride and not contribute to emission reductions because the benefits of mitigating climate change are non-rival and non-excludable. This leads to an outcome that is not socially optimal. The section concluded by drawing several lessons from game theory models that would allow for fostering cooperation between countries.
5 Exercises and questions for discussion
1 Define Pareto efficiency and discuss the advantages and disadvantages of the concept.
2 Describe the first welfare theorem. Why is this theorem a fundamental result in economics? What assump- tions underlying the first welfare theorem are violated in the case of climate change?
3 What criteria are used to classify goods as private and public goods? List two examples of a private and a pub- lic good and discuss why these goods are considered private/public by using the criteria you defined above.
4 What are open-access goods? Why is the atmosphere considered to be an open-access good? What hap- pens if markets deal with open-access goods such as the atmosphere?
5 Define externalities and provide an example of a positive and a negative externality. How could govern- ments solve a negative externality problem? Illustrate your reasoning using the example of GHG emissions.
6 Consider a coal plant that releases CO2 emissions into the atmosphere while producing units of energy. Suppose that the private marginal cost of the plant is given by PMC = 50+0.25*Q, where PMC is the private marginal cost in US dollars per unit produced and Q is units of energy produced. Because the firm releases
CO2 emissions into the atmosphere, it imposes an external cost on society that equals US$2 per unit of en- ergy produced. Suppose further that the private marginal benefit (PMC) – which equals the social marginal benefit (SMC) – per unit of energy produced is given by PMB = SMB = 100-0.25*Q.
(a) Derive the social marginal cost (SMC) function in US dollars per unit produced. (b) Draw a diagram illustrating the private marginal cost function, the social marginal cost function, and the private marginal benefit function. (c) Find the profit-maximizing energy output of the coal plant and the corresponding price per unit of energy produced. (d) Find the socially optimal energy output and the corresponding price. (e) Compare the private equilibrium with the socially optimal outcome and discuss underlying externality issues.
7 Suppose player A and player B play a game with the following payoff matrix:
Player B
Left Right
Top 1,1 -1,-1 Player A Bottom -1,-1 1,1
(a) Define dominant strategies. Does player A have a dominant strategy? Does player B have a dominant strategy? (b) How many pure-strategy Nash equilibria can you find in the game? (c) Can you find a real-world example that could be described by such a payoff matrix?
8 How does economic theory explain why the international community has been struggling for decades to solve the climate change problem? To analyse this question, suppose that the world is composed of two countries and discuss the payoff matrix of the mitigation game. What is the likely outcome of this game? Explain the lessons that can be learned from this simple game.
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module The The economics of climate change 80 ANNEX 1 Environmental economics theory Game and externalities Public goods model the competitive of market Microeconomic foundations Topic Press. Cambridge, MA. Common MandStaglS(2004). Ecological Economics –AnIntroduction. Cambridge University Kolstad (2000). CD Environmental Economics . Oxford University Press. New York. Education Limited. Essex, UK. Perman al. et (2011). Natural Resource andEnvironmental Economics. Fourth Edition. Pearson Pearson International Edition. Addison Wesley. Boston. Tietenberg T, andLewis L(2012). Environmental andNatural Resource Economics, Ninth Edition. of America. Washington, DC. Straffin P(2004). Game andStrategyTheory , Fifth Edition. MathematicalThe Association in Economics. Prentice Hall. River, UpperSaddle NJ. Chapter 13ofPindyck R, andRubinfeld D(2012). Microeconomics, Eighth Edition. Pearson Series Ninth Edition. W.W. &Company. Norton New York. Chapter 28of Varian (2010). HR Intermediate Microeconomics: Approach AModern , New York. ofMas-Colell al. et (1995).Chapters 7–9 Microeconomic .Theory Oxford University Press. Edition. Pearson Education Limited. Essex, UK. Chapter 4ofPerman al. Ret (2011). Natural Resource andEnvironmental Economics, Fourth in Economics. Prentice Hall. River, UpperSaddle NJ. Chapter 18ofPindyck R, andRubinfeld D(2012). Microeconomics, Eighth Edition. Pearson Series Chapter 11ofMas-Colell al. et (1995). Microeconomic .Theory Oxford University Press. New York. Ninth Edition. W.W. &Company. Norton New York. Chapters 34and36of Varian (2010). HR Intermediate Microeconomics: Approach AModern , New York. ofSandler T (2004). GlobalCollective. Action Chapters 2–4 Cambridge University Press. Pearson inEconomics. Series Prentice Hall. River, UpperSaddle NJ. and16ofPindyck R, andRubinfeldChapters 1–9 D(2012). Microeconomics, Eighth Edition. Press. New York. 10, ofMas-Colell al. et Chapters 1–5, (1995). and15–20 Microeconomic Theory. Oxford University Approacha Modern , Ninth Edition. W. W. &Company. Norton New York. of Varian (2010). HR and31–33 Intermediate 18–23, Microeconomics 14–16, Chapters 1–9, additional reading material Selected The economics of climate change
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