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BI-WEEKLY TOPICS: Negative externalities

Diqiucun_Cunmin
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8/16/2015 10:43:44 AM
Posted: 1 year ago
Most DDOers should be aware of the term 'negative externalities', which refers to 'unintended consequences' of certain actions on others. The purpose of this thread is, of course, not to repeat what most DDO users already know, but to a) provide a theoretical framework on which users can subsequently base their discussions on the environment (rare as they are, compared to extensive discussions on race and sexuality, on this site) and to b) stimulate discussion on the various methods to internalise externalities, or whether they should be internalised at all.

Let's start with Micro 101. The graph below is made up of two sets of curves. The first is the supply and demand curves, and the second is the marginal cost and marginal benefit curves. As the former is derived from the latter, I have represented them as one curve.

http://www.debate.org...

When you look at MC and MB, the independent variable is the x-axis (quantity) and the dependent variable is the y-axis (cost/benefit in dollars). In our diagram, the first unit of, say, cookies that you consume is worth $100 dollars to you because you're the Cookie Monster. This is MB. The producer can produce the first unit of cookies for free. That's MC.By the law of diminishing marginal returns, in the short one, as more and more quantities of your variable factor is added to the fixed factors, holding technology constant, marginal product (how much you get for each unit if input) will eventually diminish, so the marginal cost of producing each additional unit will increase. By the law of diminishing marginal benefit, you'll be a bit fuller after your first cookie, so your second cookie will worth a bit less to you. Let's put it at $90 MB and $10 MC.

Supply and demand are derived from this. When you look at S and D, the price is the independent variable and the quantity is the dependent variable. If the price of each cookie is $100, you'll consume one cookie and refuse the second because the price, $100, is higher than your value, $90. This means your quantity demanded (Qd) is 2. If the price is $90, you'll consume two cookies and stop at that. Same goes for the supply. The Qs is 1 at $0 market price. It is 2 at $10 market price. etc, etc.

When we have ridiculously high or low prices (excess supply & demand), there will be a downward and upward pressure on market price, respectively. The invisible hand will, in theory, eventually push the price and quantity to the equilibrium - cookies cost, say, $50 each, at which six cookies are transacted.

This market is efficient. By efficient, we mean the 'goodness', i.e. total social surplus (TSS), is maximised. This consists of consumer and producer surplus. CS is found by adding up (MB - P) at each unit. The PS is found by adding up (P - MC) at each unit. (PS is, mathematically, profits + fixed cost.) Compare the above diagram with this (where a price floor, typically minimum wage, pushes up the price to produce a deadweight loss):

http://www.debate.org...

This shows that government intervention in the market prevents efficiency. This concept does have exceptions, known as market failure. First, this only works in perfectly competitive situations. That isn't our concern here. Externalities are also a cause of market failure, which means the free market does NOT maximise TSS to produce efficiency. As this post is about environmental problems, not environmental benefits, I will only cover negative externalities,

Imagine you're a factory owner. For every unit you produce, you discharge slag into the river. This creates an external cost, ie there's an additional cost in production that doesn't affect you. The cost to you is private cost, and you add that to the external cost to get social cost. Like the price ceiling, this will lead to a deadweight loss.

Refer to this simplified diagram:

http://www.debate.org...

Spots = CS at market equilibrium, crosses = PS at market equilibrium, horizontal stripes = all variable costs (including external), vertical stripes = total private variable costs. The areas with only crosses or only spots and nothing else constitute the socially optimal TSS. The areas with crosses and spots (whether overlapping with other patterns or not) are the TSS before considering external costs at market equilibrium. The area with horizontal stripes but not vertical stripes is the external costs ignored. Where horizontal stripes sans vertical stripes overlaps spots or crosses, the externality is 'neutralised', but the bit where you have horizontal stripes and no other patterns is the net loss compared to the socially optimal TSS, i.e. it's the deadweight loss.

So the question we need to answer is, how do we move eliminate the DWL?

There are two main answers. The first one is that we only have to better enforce private property rights. Then the market will still be able to do its magic. Some say all environmental problems result from the tragedy of the commons (ie no PPR enforcement). For example, if there's no private ownership over the sea, fishermen will be eager to exploit it to the fullest, while if someone owns the seas, the owner will have incentive to regulate exploitation.

The Coase theorem posits that if transaction costs are sufficiently low and PPRs are properly enforced, we'll get an efficient outcome through bargaining.

Let's use a simpler example first. You play heavy metal at night and there are no laws stopping you. If your metal is worth $100 and your neighbour's sleep $90, you will either pay your neighbour between $90 and $100 to continue playing (she has rights), or you'll ask her to pay you >=$100 to stop you from playing (she'll deny it and put up with it). If your music is worth $90 and her sleep $100, she'll either pay you to $90-$100 to stop playing (you have rights) or ask you to pay over $100 to continue playing (you'll deny it and stop playing). Either way, higher-valued option wins.

Now let's use our example and assume that there are no transaction costs. If the fishermen have rights over the river, you can pay them compensation equivalent to the external costs (since that's equivalent to their loss). Now that they've had you internalise the external costs, your MPC will shift to the left, right where the socially optimal point is, and ta-daa, the market's efficient. You obviously aren't happy with this, so you bribe a local official to announce your rights over the river. Now, they'll pay you to produce less instead, so the opportunity cost of producing more is the compensation gained from them. Again, this pushes the MPC curve to the left and woohoo, problem solved.

An alternative would be to merge the factory's firm and the fisherman's firm so that the factory must consider the interests of both.

Now, if transaction costs are high, that clearly won't happen. Some economists believe that this means there was no market failure in the first place. Others disagree.

The other school of thought is to use government intervention. This is usually achieved with taxes or quotas (or governments could regulate production methods to reduce the external costs). Per-unit taxes increase the marginal private cost, and when done right, we can move the MPC curve to the socially optimal point:

http://www.debate.org...

We could also do this with quotas. At the socially optimal quantity, the firms aren't allowed to produce any more:

http://www.debate.org...

Some economists prefer this as it guarantees reduced production and we don't have to rely on theoretical market forces. Others find it inefficient - there are costs in legislation, implementation, etc., which are higher than the cost of using market forces.

What do you think? Are private property rights sufficient?
The thing is, I hate relativism. I hate relativism more than I hate everything else, excepting, maybe, fibreglass powerboats... What it overlooks, to put it briefly and crudely, is the fixed structure of human nature. - Jerry Fodor

Don't be a stat cynic:
http://www.debate.org...

Response to conservative views on deforestation:
http://www.debate.org...

Topics I'd like to debate (not debating ATM): http://tinyurl.com...
InsertAliasHere
Posts: 32
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8/20/2015 7:48:54 PM
Posted: 1 year ago
At 8/16/2015 10:43:44 AM, Diqiucun_Cunmin wrote:

This is a really fascinating post; great job, mate! I wrote a paper on the Coase theorem about a year ago for an environmental economics course. I'll try to fish it out and comment on this in more depth, though I tend to lean more to the side that institutional inequities (e.g., the ability for someone like Mr. Trump to hire a bunch of lawyers to sue me, but me being unable to likewise hire enough high-caliber lawyers to defend myself) mandate government intervention in the face of negative externalities, the most significant of which is climate change.
ax123man
Posts: 317
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8/20/2015 10:58:11 PM
Posted: 1 year ago
Great post, really helped me understand this stuff.

"Are private property rights sufficient?"

That's a good question, but hides the larger issue. If government is the answer to THIS problem, then it becomes the answer to many other problems. It becomes a package deal. And the sum total of THAT cost is awfully high.
DisKamper
Posts: 63
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8/21/2015 3:18:03 AM
Posted: 1 year ago
Privatization certainly works with low transaction costs. If we could guarantee that, the solution would be obvious, but in real life, of course, transaction costs are not always low. The question becomes whether the government's best actions are better than that of a private owner in a high transaction cost scenario.

The government can guarantee at least the same level of performance as a private party by simply acting as one. It is when the government adds additional legislative, regulative elements that it becomes hard to say whether this is better or worse than simple privatization. However, if the overall outcome is worse, then the government can always revert to acting like a private owner. Thus government regulation theoretically has a greater than or equal to performance as privatization.

In any case, all this is not optimal; ideally transaction costs are low. In my view, there probably is a cheap way to reduce transaction costs which would make this all a non-issue- the question is what that is.
Diqiucun_Cunmin
Posts: 2,710
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8/21/2015 5:04:22 PM
Posted: 1 year ago
At 8/20/2015 7:48:54 PM, InsertAliasHere wrote:
At 8/16/2015 10:43:44 AM, Diqiucun_Cunmin wrote:

This is a really fascinating post; great job, mate! I wrote a paper on the Coase theorem about a year ago for an environmental economics course. I'll try to fish it out and comment on this in more depth, though I tend to lean more to the side that institutional inequities (e.g., the ability for someone like Mr. Trump to hire a bunch of lawyers to sue me, but me being unable to likewise hire enough high-caliber lawyers to defend myself) mandate government intervention in the face of negative externalities, the most significant of which is climate change.

Thanks for your interest in the post! ^^ You're much more qualified than I to talk about the matter; I've only learnt about it at the high-school level. I'd be glad to read your thoughts :D
The thing is, I hate relativism. I hate relativism more than I hate everything else, excepting, maybe, fibreglass powerboats... What it overlooks, to put it briefly and crudely, is the fixed structure of human nature. - Jerry Fodor

Don't be a stat cynic:
http://www.debate.org...

Response to conservative views on deforestation:
http://www.debate.org...

Topics I'd like to debate (not debating ATM): http://tinyurl.com...
Diqiucun_Cunmin
Posts: 2,710
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8/21/2015 5:09:24 PM
Posted: 1 year ago
At 8/20/2015 10:58:11 PM, ax123man wrote:
Great post, really helped me understand this stuff.
Thanks ^^
"Are private property rights sufficient?"

That's a good question, but hides the larger issue. If government is the answer to THIS problem, then it becomes the answer to many other problems. It becomes a package deal. And the sum total of THAT cost is awfully high.
With regards to government intervention in environmental issues, I've heard similar comments multiple times before, that allowing more government intervention opens a can of worms. However, I believe that the argument commits a slippery slope fallacy, as I have yet to see an actual example of this happening. What do you think?
The thing is, I hate relativism. I hate relativism more than I hate everything else, excepting, maybe, fibreglass powerboats... What it overlooks, to put it briefly and crudely, is the fixed structure of human nature. - Jerry Fodor

Don't be a stat cynic:
http://www.debate.org...

Response to conservative views on deforestation:
http://www.debate.org...

Topics I'd like to debate (not debating ATM): http://tinyurl.com...
Diqiucun_Cunmin
Posts: 2,710
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8/21/2015 5:14:54 PM
Posted: 1 year ago
At 8/21/2015 3:18:03 AM, DisKamper wrote:
Privatization certainly works with low transaction costs. If we could guarantee that, the solution would be obvious, but in real life, of course, transaction costs are not always low. The question becomes whether the government's best actions are better than that of a private owner in a high transaction cost scenario.

The government can guarantee at least the same level of performance as a private party by simply acting as one. It is when the government adds additional legislative, regulative elements that it becomes hard to say whether this is better or worse than simple privatization. However, if the overall outcome is worse, then the government can always revert to acting like a private owner. Thus government regulation theoretically has a greater than or equal to performance as privatization.
Agreed.
In any case, all this is not optimal; ideally transaction costs are low. In my view, there probably is a cheap way to reduce transaction costs which would make this all a non-issue- the question is what that is.
What sort of method do you think this may be?
The thing is, I hate relativism. I hate relativism more than I hate everything else, excepting, maybe, fibreglass powerboats... What it overlooks, to put it briefly and crudely, is the fixed structure of human nature. - Jerry Fodor

Don't be a stat cynic:
http://www.debate.org...

Response to conservative views on deforestation:
http://www.debate.org...

Topics I'd like to debate (not debating ATM): http://tinyurl.com...
ax123man
Posts: 317
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8/21/2015 5:37:25 PM
Posted: 1 year ago
At 8/21/2015 5:09:24 PM, Diqiucun_Cunmin wrote:
At 8/20/2015 10:58:11 PM, ax123man wrote:
Great post, really helped me understand this stuff.
Thanks ^^
"Are private property rights sufficient?"

That's a good question, but hides the larger issue. If government is the answer to THIS problem, then it becomes the answer to many other problems. It becomes a package deal. And the sum total of THAT cost is awfully high.
With regards to government intervention in environmental issues, I've heard similar comments multiple times before, that allowing more government intervention opens a can of worms. However, I believe that the argument commits a slippery slope fallacy, as I have yet to see an actual example of this happening. What do you think?

I don't think you can really "see" it. There isn't necessarily a direct connection between policy A and B. Citizens tend to give a government a certain amount of power and any given policy either falls within or outside that.