Addressing Externalities: Negotiation, Adjudication, and Legislation

1. “The Economic Way of Thinking”11th Edition Chapter 12: Externalities and Conflicting Rights

2. Chapter 12 Outline • Introduction • Externalities, Negative and Positive • Perfection is Unattainable • Negotiation • Reducing Externalities Through Adjudication • The Case of the Complaining Homeowner

3. Chapter 12 Outline • The Importance of Precedents • The Problem of Radical Change • Reducing Externalities Through Legislation • Minimizing Costs • Another Approach: Taxing Emissions • Licenses to Pollute

4. Chapter 12 Outline • Efficiency and Fairness • The Bubble Concept • Rights and the Social Problem of Pollution • Traffic Congestion as an Externality

5. Introduction • Decision Making • Individuals choose their courses of action by weighing the expected marginal benefits of any decision against its expected marginal costs. • To affect the decision, benefits and costs for others must matter to the actor.

6. Externalities, Negative and Positive • External Costs (spillover costs) • Negative externalities • Costs not considered in decision making. • Congestion caused by slow drivers creates extra travel time.

7. Perfection Is Unattainable • Negative externalities cannot be completely eliminated. • Transaction costs • Are the costs of arranging contracts or transaction agreements between suppliers and demanders.

8. Perfection is Unattainable • Scenario • Motorcycle rider leaves home early in the morning. • Imposes on neighbors still asleep. • Question • Why don’t they pay him to push his cycle out of the neighborhood prior to starting it?

9. Perfection is Unattainable • Internalizing Externalities • When individuals take into account the externality when making a decision.

10. Perfection is Unattainable • Industrialized Societies • Negative externalities multiply. • Civil people ignore negative externalities. • Must cultivate civic virtues. • Empathy • Courtesy • Humility • Tolerance

11. Negotiation • Negotiation is used to minimize social problems created by negative externalities. • Negotiation produces mutual gains from exchange. • Failure to negotiate creates high costs to others.

12. Negotiation • Clearly defined property rights provide the basis for negotiation.

13. Reducing Externalities Through Adjudication • Adjudication • A process for deciding who has which rights. • Clarifies property rights. • Question • Which would happen if no one knew what to do or what to expect from others?

14. The Case of the Complaining Homeowner • Person buys a house. • Airport is built nearby creating noise. • Should the owner be compensated for the costs created by the airplanes?

15. The Case of the Complaining Homeowner • Questions • Would compensating one require compensating others? • Is this heavy cost on airlines and airports justifiable? • If we correct this one, do we correct all negative externalities?

16. The Importance of Precedents • Compensation for Negative Externalities • Virtually impossible to do. • Expectations indicate property rights. • Court Decisions • There is no error when the decision creates the rights. • Error is possible when the decision seeks to discover the rights.

17. The Importance of Precedents • Adjudication • Tries to avoid unexpected outcomes. • Tries to support expectations that are most widely and confidently held. • Tries to maintain a continuity of expectations.

18. The Problem of Radical Change • Technology sometimes forces rapid changes. • New rules must be formed if negative externalities rapidly multiply. • Rising incomes have created changes in property rights. • Cost of pollution has changed.

19. The Problem of Radical Change • We now place a high value on clean air. • Clean air as a right. • Requires new rules.

20. Reducing Externalities Through Legislation • The creation of new rules is legislation. • Legislation clarifies property rights • Changing the rules of the game always raises the question of fairness and compels major changes in behavior.

21. Reducing Externalities Through Legislation • The challenge for a society is to legislate • To avoid gross injustices • Minimize cost of achieving objectives

22. Minimizing Cost • Minimizing cost isn’t the only consideration when government officials are trying to achieve some objective. • Fairness is also a criterion for the evaluation of government decisions.

23. Another Approach: Taxing Emissions • It is difficult at times for government agencies to determine unit cost. • Polluters have an incentive to exaggerate their costs. • To resolve this kind of information scarcity in the least costly manner, the EPA could impose a tax per unit of emissions.

24. Another Approach: Taxing Emissions • Pollution is a spillover cost, a cost not borne by its producer. • If the per unit cost of a pollutant is set equal to the spillover cost per unit, then the creator of the costs is made to bear them. • With the tax, less pollution will occur. • Question • At what point would pollution cease?

25. Another Approach: Taxing Emissions The task of the EPA is to compare the marginal cost of reducing the emissions with the marginal benefits.

26. License to Pollute • Most pollution is: • A cost. • Not a crime. • Pollution tax becomes a • License to pollute.

27. Efficiency and Fairness • Some people object to taxes on pollutants because they regard such taxes as unfair. • They supposedly place the whole burden of the tax on the poor, while allowing the rich to go on fouling the environment. • It must be shown that the efficient solution can be achieved while settling the fairness issue in different ways.

28. Efficiency and Fairness • Some people • Object to pollution taxes as unfair • Tax burden to the poor • Allow the rich to foul the environment. • An efficient and fair solution is achievable. • The tax approach is • In general superior vs. physical restrictions.

29. Bubble Effect Concept • A giant bubble exists over the whole firm • Control total emissions into the bubble. • Under this policy firms • Allow emissions to rise if control is costly. • Making up where control is less costly. • Environmentalists – no one owned the right to pollute.

30. Rights and Social Problem of Pollution • Pollution • A major social and political concern. • People disagree about rights. • Demand for any good • Never completely inelastic. • Including clean air. • Control should be avoided • People should choose pollution reduction which lowers costs to themselves.

31. Traffic Congestion as an Externality • Traffic congestion • Negative externality • Cost generated when ignored in decision process • Only recognize cost others create • If motorists had to pay • Marginal congestion cost • Drive when benefits exceeded costs

32. Traffic Congestion as an Externality • How can externalities be internalized? • Pricing (for congestion) • Tolls • Gasoline Taxes • Road construction • Not for use

33. Once Over Lightly • Spillover Costs – from people’s actions. • Spillover Costs = Externalities • Transaction Costs prevent negotiations. • Negotiation used to secure cooperation. • Clearly defined property rights ease negotiations. • Some pollution reduction activity is more efficient than others.

34. End of Chapter 12 QUESTIONS?