Chapter 2: EXTERNAL EFFECTS

CHAPTER 2

Contents

1. Importance of externalities 2. Types of externalities 3. Consequences of externalities 4. Causes of externalities

1. Importance of externalities

Definition: Externalities arise if the activities of an actor (or a group of Definition: actors) influence the possibilities of production or consumption of a External Effects third party (e.g., households, producers, general public, future generations, etc.) without this influence being incorporated into prices via the market mechanism.

Externalities can be positive or negative (see fig. 2.1.). However, as far as environmental problems are concerned, negative externalities are at the center of attention. “Negative” means a restriction of the possibilities of production or consumption of a third party without this restriction being mirrored in market prices.

2. Types of Externalities

Fig. 2.1: Types of external effects

Abb. 2.1: Types of external effects

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Examples for different types of externalities: a) Negative externality which influences the possibilities of production for a third party: A steel mill dumps its pollutants into a nearby river. Thereby, the fish population declines and a fisher further down the river experiences a decline in production. Nevertheless, since the fisher is no monopolist, the market price for fish remains the same. b) Positive externality which influences the possibilities of production for a third party: An apple grower and a beekeeper work on adjoining premises. Both profit from each other’s production: The bees aim on the apple’s pollen, and the apples get pollinated by the bees. However, neither the apple’s nor the honey price changes. c) Negative externality which influences the possibilities of consumption for a third party: Tenant A and tenant B live in the same building. Tenant A listens extensively to very loud music, which is not enjoyed by tenant B, i.e., tenant B cannot consume silence. The rent, however, remains unchanged. d) Positive externality which influences the possibilities of consumption for a third party: Tenant A and tenant B live in the same building. Tenant A listens extensively to very loud music, which happens to be the favorite style of tenant B as well. Hence tenant B profits from the music collection of his neighbor. The rent, however, remains unchanged.

3. Consequences of externalities

Allocational efficiency The existence of externalities poses a problem to economic theory. One objective of economic analysis is to identify the mechanisms whereby scarce economic resources (in this case: “the environment”) are allocated to the economic actors who would value them most. If – as in the case of externalities – not all relevant cost and benefits are incorporated in relative prices, the allocation of resources via the market mechanism will lead to an inefficient outcome. This relates to the concept of allocational efficiency which lies at the very heart of economic theory. An operational definition of allocational efficiency (and one which is omnipresent in economics) is implied by the concept of “Pareto Efficiency” 1:

An allocation of resources is Pareto-efficient if there exists no Definition: possibility to make one actor better off without reducing the welfare Pareto-Efficiency of another.2

1 The term ‘Pareto-efficiency’ is named after the economist and sociologist Vilfredo Pareto (1848-1923). 2 As we will see in the following chapters, this criterion is not met in the case of externalities. Those affected by emissions, for example, could compensate the polluting actor for reducing emissions, which would make both parties better off. 2 CHAPTER 2

An efficient allocation of a certain good implies that the (social) marginal cost of this good are equal to its (social) marginal benefit. The existence of externalities implies that the allocation of resources will not be Pareto-efficient, because prices do not include all marginal social costs. Hence, the social optimum (or Pareto-optimum) is unattainable for reasons explained in the following paragraphs.

The problem with externalities Firms’ and individuals’ decisions with respect to supply and demand are depending on relative prices in the economy. The existence of externalities distort relative prices, since prices no longer mirror the relative scarcity of the respective goods or production factors. Hence, actors’ decisions are based on “wrong” relative prices and are, therefore, not Pareto-optimal.

Fig. 2.2: Individually optimal decisions

The quantities xA and yA as seen in figure 2.2 mirror the household’s optimal consumption in point A with prices being px and py, respectively. Let’s assume that the production of X involves some externalities, like, for example, the emission of pollutants. If these externalities were incorporated in the price system, the market price of X would have to rise (px’ > px). If all costs were incorporated in prices, the household’s budget restriction would be steeper (since the slope of the budget line is determined by the price ratio – px/py). In this case the household’s optimal consumption would be xB, yB, i.e. the household would now consume less of good X (xB < xA). However, while externalities change the “true” relative scarcities of goods, this change is not mirrored in prices, because externalities are by definition not incorporated in market prices. Therefore, the household still chooses xA and yA, respectively. This, however, is now no longer an optimal choice, since relative prices no longer correctly reflect relative scarcities.

The welfare loss due to externalities:

W We take a look at the market for good 1 (or X, respectively) and we’re still assuming the existence of externalities.

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Fig. 2.3: Effects of externalities on social welfare

Fig. 2.3: Effects of externalities on welfare Figure 2.3 shows the supply and demand curve for X. The supply curve corresponds to the marginal costs for the firm producing X. The demand curve corresponds to the marginal benefit of households consuming X. The market clears at price p2U with the quantity x2 produced and consumed. Let’s go back to the fisher-steel-mill example. The production of X (steel) involves external costs (for example due to river pollution). These externalities, however, are not taken into account by the firm for its cost calculation. So at any given quantity of X, the marginal costs for society are higher than the marginal costs for the X-producing firm (for example the steel mill). If all relevant marginal costs are taken into account, the social optimum is no longer at x2 and p2U (point B), but at x1 and p1, implying a higher price and a smaller quantity of X in equilibrium. As long as the externality exists, however, the social optimum cannot be reached, since p2U remains unchanged and therefore neither the supply nor the demand side has any incentive to deviate from x2.

Comparison of the social optimum to the feasible de-facto market equilibrium: If the feasible market equilibrium is B instead of A, a net welfare loss is implied: There are additional costs to society in B which surpass the additional benefit resulting from a higher level of consumption of X. These additional costs correspond to the area X1X2CA in figure 2.3, i.e., the social costs of producing the quantity (X2-X1) of good X. These costs are higher than the social benefit from producing the quantity (X2-X1) of X, which corresponds to X1X2BA. Thus, the net welfare loss equals the triangle ABC in figure 2.3.

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An alternative presentation of externalities:

Negative externalities like environmental damages are unintended by-products of consumption or production, respectively. The prevention of environmental damages, however, is costly. These costs of prevention have to be compared to the costs of pollution.

Fig. 2.4: Alternative presentation – optimal level of pollution

Abb. 2.4: Alternative presentation: optimal level of pollution

The GS curve in figure 2.4 depicts the marginal damage to society due to pollution. The underlying assumption here is that not only total pollution V, but also the additional damage to society is rising with production. That is, for any additional unity of good X produced, the additional pollution gets increasingly severe. The costs of abating an additional unity of pollution are represented by the GKV curve in figure 2.4. It is assumed that the more pollution has already been prevented (i.e., the smaller p), the higher the costs of abatement for an additional unit. At v0, no prevention takes place. Prevention costs are, therefore, zero. The Pareto-optimal amount of prevention is marked by v1 at the intersection of the MD and the MCA curve. This is the point where the marginal damages to society due to pollution equal the marginal costs of pollution prevention. As this is the first order condition for a minimization of the overall cost, v1 is an optimum from the perspective of environmental economics.

The amount of v1 depends on the position of the GS and the GKv curve, respectively: - the higher the position of the GS curve (i.e., the higher the damages suffered and perceived by society), the smaller v1 - the lower the position of the GKv curve (i.e., the lower the costs of pollution prevention), the smaller p1

Conclusion: The socially optimal amount of pollution is not zero, but dependent on consumptive and environmental preferences of actors.

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Approaches for an internalization of externalities

Internalization means to modify the actors’ decision-making framework in a way to incorporate externalities. In other words: Any change in the possibilities of production or consumption of a third party has to be mirrored by a change of market prices.

Internalization can be achieved in four different ways:

1. via negotiations, i.e. through private agreements between actors 2. via government regulations targeting prices (through taxes) 3. via government regulations targeting quantities (through environmental standards or emission rights) 4. via environmental education (heighten the public awareness of environmental problems)

4. causes for externalities

In most cases, negative externalities are related to environmental goods which show the characteristics of ‚public’ goods and for which no specific property rights exist. Public goods are defined by two criteria, namely non-rivalry and non- Definition: exclusiveness in consumption (for example, the air that we breathe, Public Good street lighting)

Pure public goods are rare, since especially non-rivalry in consumption only holds to a certain extent (like with, for example, air pollution). It is a crucial point in the consideration of environmental problems that environmental goods which fulfil the criteria of a public good can be consumed at no cost due to their non-exclusiveness. That means that nobody consuming a public environmental good has to make any contribution to its maintenance (like, for example, keeping the water of lakes and rivers clean). This phenomenon is known in economics as the free-rider problem. Free-riding behaviour can lead to a sub-optimal outcome at the societal level: the quality of the environment deteriorates. The reason for this outcome can be analysed using the so-called prisoners’ dilemma (see figure 2.5).

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The Prisoners’ dilemma:

Fig. 2.5: Prisoners’ dilemma

The prisoners’ dilemma is a classical two-persons-non-zero-sum game and an important concept of game theory. Figure 2.5 depicts the decision-making framework of two persons who have been arrested as suspected burglars. To prevent any dealings between the two suspects, they have been locked in different prison cells. Since there is no definite proof that either of the suspects is in fact guilty, the police tries to make each prisoner confess the crime by offering him the following deal: • If both confess, each will be convicted to four months in prison. • If neither confesses, each will be convicted to two months in prison. • If only one confesses, the confessor will receive one month in prison, whilst the non-confessor will receive a harsh punishment of five months. Given that framework, the rational calculation of prisoner 1 goes as follows: “If prisoner 2 confesses, I will be better off by confessing as well (four months in prison instead of five months). If prisoner 2 does not confess, I will still be better off by confessing (one month in prison instead of two months. So, regardless what prisoner 2 does, I will be always better off if I confess.” And vice versa. The resulting equilibrium of this game (Nash equilibrium) is to be found in square one in the pay-off matrix in figure 2.5. The social optimum, however, lies in square four and implies non-confession by both players.

The prisoners’ dilemma and environmental economics: The prisoners’ dilemma can be used to analyse the problem of public environmental goods. Consider the following example: Let’s assume that the provision of an environmental good (e.g., the improvement of water quality) is associated with the following costs and benefits for two actors (or groups of actors, respectively): • If only one actor makes an effort towards the provision of the good, only one unit of the good will be provided. This provision of one unit

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costs 40 and implies a benefit of 30 for each actor. However, in this case only one actor makes a contribution, whereas both actors profit from that contribution due to non-exclusiveness (public good). Hence, the net benefit for actor 1 would be -40 + 30= -10, whereas the non- contributing actor 2 had a net benefit of 0 + 30 = 30. • If both actors contribute towards the good, two units will be provided at total costs of 2*40=80 and a total benefit of 2*30=60, implying a net benefit of -40 + 60 = 20 for each actor. • If none of the actors contributes towards the provision of the good, there will be no resulting costs and benefits, of course.

The resulting pay-off matrix is shown in figure 2.6

Fig. 2.6: user 2 Pay-off matrix in a non- participation public good game user 1 participation

participation ( 20 , 20 ) ( -10 , 30 )

non- ( 30, -10) ( 0 , 0 ) participation

Abb. 2.6: example – Pay-off matrix in a public good game Figure 2.6 is analogous to the classical prisoners’ dilemma in figure 2.5. The resulting Nash-equilibrium is to be found in square 4, where none of the actors makes a contribution towards the good, whilst the Pareto optimum would be in square 1, i.e., at the co-operative solution, where both parties contribute. But since the environmental good is a public good and therefore non-contributing actors cannot be excluded from its benefits, contribution is not an attractive strategy for the rational actor. This “social dilemma” results in an under- provision of environmental goods.

Conclusion: Due to the special characteristics of most environmental goods as public goods without any specific property rights assigned, and due to the free-rider problem, negative externalities prevail in many areas of environmental politics.

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Literature

Frey, René L. Staehlin-Witt, Elke, Blöchliger, Hansjörg: Mit Ökonomie zur Ökologie, Basel/Frankfurt am Main, Stuttgart: Helbing&Lichtenhahn, 1993, 2. Auflage, S. 39 - 55.

Bartel, R. Allgemeine Grundlagen der Umweltpolitik, in: Bartel, R. Hackl (Hrsg.), Einführung in die Umweltpolitik, München: Vahlen, 1994. S. 3-32.