Externalities are a common concept, that we unknowingly encounter each day.

Externalities relate to the spillover costs or benefits that arise from the consumption or production of goods and services. To put this more simply, your friend’s consumption of products can sometimes have an effect on you. For instance his increased level of education can make him a valuable asset in quiz games, or his over-indulgence in caffeine can make him a hard person to work with in class. Sometimes society would prefer more social benefits and less of the spillover costs. The concept is called a social equilirium, where price and quantity reflect the social beliefs.

Spillover costs and benefits are things that exist in many nations. Governments for instance, work hard to discourage consumption of products with substantial spill over costs such as alcohol, cigarettes or chewing gum in Singapore. They will also aim to subsidize the production of goods, which generate positive spillover costs such as public gyms, swimming pools, running tracks or national immunization schemes.

Here are a few examples from Singapore to get you thinking about this new topic.

Negative Externality of Consumption – Cars

Living on a small island a mere 50km by 60km with 5 million people brings about many problems including traffic congestion. Whilst Singapore has an excellent system of public transport, including buses and a subway system, people still demand cars in ever increasing quantities. The spillover effects of private car use are traffic congestion and pollution. The government therefore has developed an array of policies to curb the rate of car ownership.

• When you purchase a new car you must pay, an additional 100% of the cars value to the government as an indirect tax. Imagine a new Audi, retailing for $50,000 now costing $100,000 including the tax.
• When you purchase a car you must also purchase a registration permit to drive it on the roads. These permits last for 10 years, after which you must sell the car overseas. A permit is sold through an auction system. When the demand for cars is high the price of the permit rises and demand for new cars may drop. A permit for a 2 litre engine car costs about $14,000 SGD for 10 years.
• Throughout the inner city and freeway system an electronic road-pricing scheme operates. When you drive you car under one of the gantry’s you pay a small congestion tax which is deducted from a debit card in your car. When congestion is high the early evenings the congestion tax is increased from $0.50c to $1.50 on bad days. An evening commute can result is five or six congestion charges, costing drivers anything between $6 and $12.

Negative Externality of Consumption – Chewing Gum
Chewing gum is a product, that to different people, brings either a cost or benefit to society. The consumption of chewing gum can boost the production of saliva and help reduce chance of tooth decay. On the other hand chewing gum is a sign of urban decay with pavements littered with sticky blobs and grey scars.

The Singapore government feels that society would to prefer to minimize the spillover costs of chewing gum. Instead of imposing a tax on a packet of gum, it has been banned. You can not buy gum at any supermarket in Singapore. The result is pristine pavements that allows council cleaners to focus on other tasks.

Funnily enough, the nicotine gum (used to help smokers kick the habit) is legal with a prescription from your doctor.

Discussion Questions:

1. Why is chewing gum not banned in every country, if it produces spill over costs?
2. What are some possible alternative government interventions to reduce traffic congestion in Singapore?
3. Can you apply the concept of externalities to the consumption of deodorant? Draw a graph to show the private and social equilibriums.

The elasticity, or perceived necessity of different products can influence the decision to introduce a tax. In Russia, two products, Beer and Vodka are being looked at as a potential sources of new government revenue. A proposed increase in the tax duties on beer, will potentially increase retail prices by between 20-30%. An increase in the price of one form of alcohol (beer) could shift demand towards other close substitutes, such as vodka or home brewed spirits. Hopefully, increased tax revenue will support the government finances and in the long run, the money could be reallocated to treat alcoholism.

An Economist article from last week gives a good analysis of this issue. Russia is a country where people drink 30 litres of hard liquor alcohol each year, six times more than the average European. Alcohol taxes are a sensitive subject, and the implications complex, but they need to be addressed.

The Economist – Russia raises tax on beer: Sin-Tax Error

Discussion Questions:

1. “Pushing up beer prices is far more likely to encourage drinkers to swallow even more vodka.” What does this quote suggest, about the cross elasticity of beer and spirits in Russia. Use evidence from the article so support your explanation.
2. The Russian government is suggesting adding a tax to beer.  What effect do you think this will have on the market price and market quantity of beer consumed.
3. The government wishes to impose a tax on these products. Assume a specific tax is imposed on each product. Assume the demand for beer is relatively elastic and the demand for vodka relatively inelastic and draw two graphs to show the effect on consumers and the relative tax burdens.
4. Explain what the aim of introducing taxes on vodka and beer is. Evaluate if the taxes will achieve the aims of increasing government revenue and reducing the social harms related to alcohol consumption in Russia.

Econ professor and blogger Tim Haab has posted a great story on market failure, efficiency and corrective taxes at his blog, Environmental Economics: I love when someone else does my work for me.

With appreciation, I re-post his blog here in its entirety. Tim’s “Questions to consider” are perfect for IB and AP Econ students to answer in their Market Failure unit. Read and answer Tim’s discussion questions in the comments:

Today’s Econ 101 topic–actually AED Economics 200 but same diff–the deadweight loss from taxes in otherwise well-functioning markets. In my neverending–futile?–attempt to stay current, I plan to use this example from today’s Wall Street Journal:

Senate leaders are considering new federal taxes on soda and other sugary drinks to help pay for an overhaul of the nation’s health-care system.

The taxes would pay for only a fraction of the cost to expand health-insurance coverage to all Americans and would face strong opposition from the beverage industry. They also could spark a backlash from consumers who would have to pay several cents more for a soft drink.

The Center for Science in the Public Interest, a Washington-based watchdog group that pressures food companies to make healthier products, plans to propose a federal excise tax on soda, certain fruit drinks, energy drinks, sports drinks and ready-to-drink teas. It would not include most diet beverages. Excise taxes are levied on goods and manufacturers typically pass them on to consumers.

…

The Congressional Budget Office, which is providing lawmakers with cost estimates for each potential change in the health overhaul, included the option in a broad report on health-system financing in December. The office estimated that adding a tax of three cents per 12-ounce serving to these types of sweetened drinks would generate $24 billion over the next four years. So far, lawmakers have not indicated how big a tax they are considering.

Proponents of the tax cite research showing that consuming sugar-sweetened drinks can lead to obesity, diabetes and other ailments. They say the tax would lower consumption, reduce health problems and save medical costs. At least a dozen states already have some type of taxes on sugary beverages, said Michael Jacobson, executive director of the Center for Science in the Public Interest.

Questions to consider:

1. How do you reconcile the seemingly conflicting goals of reducing soda consumption and raising revenues to pay for health care?
2. Which effect do you expect to dominate: reduction in quantity demanded due to higher prices or increased revenue from higher prices?
3. Assuming the market for sodas (pop around here) is currently working efficiently, what effect do you expect a new tax to have on consumer well-being, producer well-being, government revenue and total social welfare?
4. What role do the elasticity of demand and elasticity of supply play in your answers to 1,2 and 3?

Robert Reich’s Blog: Is Obamanomics Conservative or Revolutionary?

Former Secretary of Labor and Berkely Economist thinks Obama’s federal government budget is conservative and responsible. He also likes Obama’s plan for tackling environmental problems, which uses the “cap and trade” system of using a market to internalize the environmental costs of firms’ production which in the past have been externalized due to lack of effective regulation.

What about the environment? Isn’t cap and trade a huge deal? Not at all. Instead of heavy-handed regulation it’s a market solution to the problem of global warming. Government merely sets an overall cap on the amount of carbon dioxide to be allowed into the atmosphere, which drops annually, and then requires firms to bid for permits to pollute within that overall cap. Firms can buy and sell permits to each other; they can innovate to reduce pollution even further. Such a system will generate enough revenues to give 95 percent of Americans a yearly refundable tax credit of $400, and also finance research and development of renewable energy and a modernized electricity grid.

There’s much more to this excellent post by economist Robert Reich, and I recommend anyone interested in economics give it a read.

Below is an illustration of the effect that a “cap and trade” program will have on the cost of firms to pollute, showing that over time the amount of permissible pollution can be tightened thereby increasing the incentive for firms to reduce greenhouse gas emissions.

Should hunters switch to ‘green’ bullets? – CNN.com

Chis Rock once said,

“We don’t need gun control, we need bullet control. I think a bullet should cost $5,000, cause if a bullet cost $5,000 there would be no more innocent bystanders.”

Chris Rock may not have had market failure in mind when he wrote this joke, but he unknowingly demonstrated a perfect example of a case in which the over-consumption of a particular good results in spillover costs on third parties not involved in the original transaction (the “innocent bystanders”). In economics, this is known as a negative externality of consumption, and is considered a market failure because without some kind of government intervention, too much of the harmful good will be produced and consumed: in this case, too many bullets are consumed causing harm to society.

I always thought Chris Rock’s idea of taxing bullets was a good idea, but never thought I’d find a real example of such a solution to market failure, until now. Although the bullets in the article below are those used by hunters, whereas Chris Rock’s bullets are probably those used by gangsters, the economic concepts underlying the market failures are similar.

Three years ago, Phillip Loughlin made a choice he knew would brand him as an outsider with many of his fellow hunters:

He decided to shoot “green” bullets.

“It made sense,” Loughlin said of his switch to more environmentally friendly ammo, which doesn’t contain lead. “I believe that we need to do a little bit to take care of the rest of the habitat and the environment — not just what we want to shoot out of it.”

Lead, a toxic metal that can lower the IQs of children, is the essential element in most ammunition on the market today.

But greener alternatives are gaining visibility — and stirring controversy — as some hunters, scientists, environmentalists and public health officials worry about lead ammunition’s threat to the environment and public health.

Hunting groups oppose limits on lead ammunition, saying there’s no risk and alternatives are too expensive…

Lead bullets cause harm to the environment and possibly to human health. The private consumption of these bullets exceeds what is socially optimal, while “green” bullets, on the other hand, are under-consumed by private individuals. There are two market failures occurring here, and they can be illustrated as follows:
When markets fail, government action is sometimes necessary to achieve a more socially optimal allocation of resources. The bullet market represents a market failure because too many harmful lead bullets are being consumed while not enough environmentally friendly “green” bullets are being consumed.

The graphs above show the impact of corrective taxes and subsidies in resolving these market failures. Whether or not governments will pursue such corrective policies has yet to be seen. A couple of states, however, appear to already understand that market failures require government intervention.

Last year, California banned lead bullets in the chunk of the state that makes up the endangered California condor’s habitat. The large birds are known to feed on scraps of meat left behind by hunters. Those scraps sometimes contain pieces of lead bullets, and lead poisoning is thought to be a contributor to condor deaths.

Arizona, another condor state, gives out coupons so hunters can buy green ammunition. Utah may soon follow suit.

Discussion Questions:

1. Why don’t all states simply ban the use of lead bullets by hunters? Is this solution socially optimal?
2. Besides corrective taxes and subsidies, how could government reduce the demand for lead bullets and increase demand for “green” bullets?
3. How will Arizona’s use of coupons demonstrate a market-based approach to externality reduction?
4. And this one is from the authors of the Environmental Economics blog: “Do you think the deer care which kind of bullets the hunters use?”

This post is about how Switzerland has successfully employed an innovative system of incentives to encourage its citizens to reduce the amount of garbage they create. Just three weeks in this amazing country and I can already see why it earned the highest score in last year’s Environmental Performance Index.

In the AP and IB Economics units on market failure, we study the concept of negative externalities, which exist when the behavior of one individual or firm creates spillover costs to be faced by other individuals or society as a whole. A simple example is a factory that dumps waste in a river. Clearly, disposing of its waste in such a manner poses little or no cost on the factory owners, but significant costs on downstream users of the river’s water. A community that wishes to use the river for drinking water must now install expensive filtration and purifying systems just to make the water usable. The factory has kept its own costs down by externalizing the cost of filtration by passing it on to downstream users.

Spillover costs exist on micro levels as well. While it is easy to see how a large factory creates negative externalities, it is often harder to imagine how we as individuals create spillover costs for our neighbors and society in our everyday actions. The stark truth, however, is that an individual’s behavior, multiplied by millions upon millions of individuals making up a citizenry, can have as great if not greater negative impacts on the environment and society as the negligent behavior of one firm.

Here in Switzerland, the behavior of each individual citizen is subject to unusually strict scrutiny. No, Big Brother is not watching, as you may be thinking, (however, I have heard stories of snoopy neighbors alerting the police upon witnessing the most minor of infractions by a fellow citizen), rather, one finds it in his best economic interest to strictly monitor his own behavior down to the finest detail. Allow me to explain what I mean.

Let’s take garbage for example. The definition of garbage in Switzerland is very different from that in the United States. Where I’m from, garbage is anything that you can’t use anymore. You throw it “away”, put it on the curb and it disappears.

A garbage bag in the US is usually a 40 gallon (160 litre) plastic bag that could fit an entire family inside, and the typical American family probably produces two to three bags worth of “garbage” each week, which conveniently disappears in the wee hours of the morning to be taken “somewhere”, which most Americans don’t know or care to know where that is. How much does it cost an American household to dispose of this voluminous quantity of garbage? Well, the bags cost around 18 cents each, and monthly removal services vary depending on the community, but are typically a flat rate for almost any amount of garbage.

In the United States, it is very easy for individuals to pass the true cost of their garbage disposal onto society as a whole. It doesn’t matter all that much whether you put one tiny plastic bag on the curb or a half dozen 40 gallon bags on the curb, you are going to generally pay the same amount for collection regardless. The result of such a system is that the typical household has no incentive to reduce the amount of garbage that it produces. Logically, Americans are inclined to over-consume and produce copious amounts of garbage in the absence of any significant system of incentives in place to encourage waste reduction.

So, what’s different about Switzerland? It’s all about incentives. Let me explain. Here, you don’t pay a flat rate for garbage removal. In fact, you don’t HAVE to pay anything for garbage removal! Oh wow, you say, it’s FREE? In fact, quite the opposite is true. You don’t have to pay anything for garbage removal as long as you don’t create any garbage. In other words, you only pay for what you throw away.

Unlike in the US, here a typical garbage bag here is a 35 litre plastic sack, only slightly larger than a plastic grocery bag. Each village requires its citizens to buy official garbage bags for that community, and each individual bag costs anywhere from $1.50 – $2.50. A role of ten 35 litre bags can cost around $25.

When we consider that anything a household wishes to throw away must be put in an official village garbage bag which itself must be purchased for $2.25, and we know that a typical 40 gallon (160 litre) garbage bag in the US costs just $0.18, we can easily calculate and compare the costs of garbage disposal to both US and Swiss households.

• In Switzerland: 100 litres of garbage costs $6.40 to dispose of
• In the US: 100 litres of garbage costs a little over $0.11 to dispose of
• In other words, garbage removal costs Swiss households around 57 times as much per litre as it does Americans, when we consider the price of garbage bags alone.

Clearly, Swiss households are given a significant incentive NOT to create garbage. So what DO the Swiss do with all their waste? Recycle it, of course! See, here in Switzerland all recycling is free. The villages even offer free curb side pick-ups for all recyclable materials.

A simple system of incentives (and dis-incentives) is the secret to Switzerland’s environmental success. Other systems are in place to encourage citizens to use public transport, tread lightly while hiking in the outdoors, conserve energy and water at home, and behave in other environmentally friendly ways, but I’ll save my discussion of those items for another time, once I figure out how to reduce, re-use and recycle all my own “garbage” here in Zurich!

Some Britons Too Unruly for Resorts in Europe – NYTimes.com

According to the article above, Great Britain exports more trouble to the rest of Europe than any other nation.

A recent report published by the British Foreign Office, “British Behavior Abroad,” noted that in a 12-month period in 2006 and 2007, 602 Britons were hospitalized and 28 raped in Greece, and that 1,591 died in Spain and 2,032 were arrested there.The report did not distinguish between medical cases and arrests associated with drunkenness and those that had nothing to do with it. But it did say that “many arrests are due to behavior caused by excessive drinking.”

The unruly behavior of Britons does not always end when the vacation is over, either:

Earlier this summer, flying home to Manchester from the Greek island of Kos, a pair of drunken women yelling “I need some fresh air” attacked the flight attendants with a vodka bottle and tried to wrestle the airplane’s emergency door open at 30,000 feet. The plane diverted hastily to Frankfurt, and the women were arrested.

How is this story related to economics, you may be wondering? Well, it’s really about a market failure. The over-consumption of alcohol by British tourists is creating spillover costs for the societies (and police forces) of the nations in which the tourists get themselves into trouble.

As governments often do when market failures exists, some British consulates have begun taking action to reduce the negative externatlities associated with their nationals’ drunkenness.

Worried about the increase in crimes and accidents afflicting drunken tourists, the British consulate in Athens has begun several campaigns, using posters, beach balls and coasters with snappy slogans, to encourage young visitors to drink responsibly.

“When things do go wrong, they go wrong in quite a big way,” said Alison Beckett, the director of consular services. “What we’re trying to do here is reduce some of these avoidable accidents where they have so much to drink that they fall off balconies and are either killed or need huge operations.”

Because British tourists only consider their own enjoyment (benefits) while on vacation, they consume alcohol at a level that fails to take into account the social costs of their behavior. In economic terms, the marginal private benefit of alcohol consumption exceeds the marginal social benefit, representing an overallocation of resources towards alcohol in tourist towns. Government action by British consulates is aimed at reducing demand (marginal private benefit) among tourists, shifting the MPB curve back towards the MSB curve, in the hope  that alcohol consumption will decline to the socially optimal level, where marginal social benefit equals marginal social cost.

There seems to be a fine line between too much drinking and not enough in the tourist spots of Europe. As far as the impact that British drunkenness has on business, some in the tourist trade believe the very prospect of wild parties and cheap booze is what keep the local economies afloat. Crack down too much on the wild Britons, and business could collapse as customers attracted to the anarchy stop arriving.

Discussion questions:

1. Is overconsumption of alcohol a market failure? If so, what type could it be classified as?
2. If the tourist nations were serious about cracking down on drunk tourists, what economic actions could they take in the resort communities where most of the trouble occurs?
3. How are proprietors of bars and clubs in resort communities benefiting at the expense taxpayers from other parts of the tourist nations? Does the private cost of running a bar in a place like Malia, Greece reflect the social cost? Explain.

Inside Obama’s Green Budget – Forbes.com

Some say that Global Warming may be the greatest market failure of all. This podcast was originally broadcast in January of 2007 while George Bush was still in office. The commentator claims that global warming is “nothing but one giant market failure”, arguing that the United States therefore must get serious about tackling the problem.

 Global Warming - one giant market failure [1:28m]: Play Now | Play in Popup | Download

The allocation of resources towards carbon emitting industries has almost undoubtedly contributed to the warming of the planet over the last half century. Only recently have governments begun taking active measures to reduce the impact of industry on the environment through greater regulation of polluting industries, employing corrective taxes in some instances and market-based approaches to pollution reduction in others.

US President Barack Obama, unlike his predecessor, appears to be serious about correcting the “market failure” represented by global warming:

Obama’s budget, announced Thursday, looks to fund a host of new energy programs, from carbon sequestration to electric transmission upgrades. It would also provide the EPA with a $10.5 billion budget for 2010, a 34% increase over the likely 2009 budget. Nineteen million dollars of that would be used to upgrade greenhouse gas reporting measures.

The Interior Department would get $12 billion for 2010. The agency would use part of the money to asses the availability of alternative energy resources throughout the country.

Funding comes from elaborate carbon “cap and trade” program, which puts a price on emitting pollution and is the core of Obama’s plans. Starting in 2012, the government would sell permits giving businesses the right to emit pollution, generating $646 billion in revenue through 2019.

During those years, the number of available permits would gradually decline, forcing businesses to buy the increasingly scarce, and costly, rights to pollute on an open market. Obama hopes that the rising cost of permits will encourage businesses to invest in clean technologies as a cheaper alternative to meeting pollution mandates, helping to cut greenhouse gas production to 14% below 2005 levels by 2020.

Below is a diagram that illustrates precisely how the Obama cap and trade plan is meant to work. Notice that between 2012 and 2020 the cost to firms of emitting pollution will increase dramatically, while at the same time the total amount of carbon emissions in the US economy will fall due to regular reductions in the number of permits issued to industry.

The Obama cap and trade scheme is not the first experiment with such a market based approach to externality reduction:

Europe established such a market in 2005. But some E.U. governments allocated too many credits at the outset, causing the value of some permits to fall by half and making it relatively easy for large polluters to simply buy credits rather than cut emissions. Overall emissions grew in 2005 and 2006. In 2008, E.U. emissions dropped 3%; 40% of that drop was attributed to the carbon trading scheme.

Europe’s cap and trade program took a few years before it began having any noticeable impact on the emission of carbon by European industry. While unpopular among the firms who are forced to pay to pollute, the fall in emissions in Europe shows that a market for carbon may be effective in forcing firms “internalize” the costs of carbon emissions, which until now have been born by society and the environment in the form of the negative effects of global warming.

Discussion Questions:

1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
3. Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

Economics is the field of study that attempts to address the basic problem faced by society relating to the environment and natural resources: the problem of scarcity in a world of infinite wants. Many, if not all, of our planet’s environmental woes are attributable to an economic phenomenon known as market failure. A market failure results whenever too much (or in some cases too little) of a good or service is produced and consumed by the economy.

What does this have to do with the environment? The connection lies in the reality that everything we produce and consume (and I mean everything!) originates from the earth. Nothing can be made by the sweat of man alone; in fact, three resources are required to produce any good or service: labor, capital (i.e. tools), and land. Sometimes we think of the resource of land as gifts of nature. However, in a world where environmental threats like those mentioned above are staring us in the face, it is becoming more and more obvious that the natural resources we’ve exploited for so long may not, in fact, have been gifts from Mother Nature at all, and their overuse may impose significant and unaccounted for costs on society AND the environment.

But let’s be honest, consuming is fun! Nothing is more gratifying than scoring a fantastic deal at your favorite boutique, walking out of a fast food joint with a plastic bag full of tasty treats for super cheap, and getting your hands on the latest high tech gizmos as soon as they’re launched (and dumping that old technology out so you’re not the lame one with the three pound cell phone!) However, the true cost of our obsessive consumption habit is not always represented by the price we pay for our fast food, our blue jeans, and our iPod Nanos.

In reality, the prices we pay for our goods and services are far lower than they should be; and the quantity of these things we consume is far higher than it should be. How do we know this? Look around. The very environmental issues with which clubs like Roots and Shoots are most concerned can be traced back to the consumer behavior we enjoy partaking in so much. We’re conditioned to buying what we want, when we want it, and for a price that places little burden on our pocket books.

What we don’t realize, however, is that nature is bearing the burden of our high levels of consumption. In its attempt to absorb the pollutants that are emitted in the manufacture of our products, the waste that’s created from the disposal of our products, and the destruction that’s left behind from the extraction of the natural resources that go into our products, Mother Nature is more than ever choking on the waste created by our economic behavior. The costs born by nature are not accounted for in the production costs faced by firms, nor in the prices paid by consumers. These costs are externalized, or passed on for others to worry about.

The problem is, these days the bill has come due, and the environment is calling in its debts. Humans must now face up to the failures of its markets, and internalize the costs that for so long have been passed on to the environment and society, which suffers from the effects of environmental degradation.

The reality that we’ve used too many natural resources to produce too much stuff for too long is evidenced by simple examination of the natural world around us. Or, in the case of China, the complete lack of a natural world around us. From the pollution filled skies, to the waste clogged waterways, to the traffic jammed highways, China is a case study in market failure. The world, now used to the cheap imports China is so good at pumping out, does not consider the impact that the manufacture and consumption of such a massive variety of cheap products is having on China’s, and these days the world’s, environment.

In the following audio clips, you’ll hear three short stories about how the over-exploitation of resources is causing harm to human welfare and the environment. Each of these stories contains a market failure, usually in the form of a negative externality, or the production and consumption of certain goods creating spillover costs on somebody or something not involved in its production or consumption. See if you can identified who’s being harmed, and who’s at fault:

 E-waste [7:36m]: Play Now | Play in Popup | Download

 Trash Island [2:01m]: Play Now | Play in Popup | Download

 Nauru [6:57m]: Play Now | Play in Popup | Download

Story #1: “Where does all that E-waste go?” from Public Radio International’s “The World: Technology” podcast

Story #2: “Trash Island” from WBEZ Chicago’s “This American Life”

Story #3: “Nauru – the island in the middle of nowhere” from WBEZ Chicago’s “This American Life”

After listening to these stories, reflect for a moment on the true cost of the environmental and human tragedies of which they told. What role does our consumer culture play in these tragedies? What could have been done to prevent the conditions in those E-waste markets in Africa and China, the islands of garbage floating in our deep oceans, and the complete destruction of an island paradise 1,100 miles from the nearest land? Is there anyone to blame? Should we blame our politicians, our leaders? The answer to these questions is: there’s no easy answer, unless we want to get really personal here and point to humans’ own flawed nature: the fact that we are motivated primarily by greed and self-interest.

If that’s true, then perhaps hope for the environment can only be found in the responsible hands of benevolent governments, who once and for all take steps to mitigate the destructive impacts of our endless patterns of production and consumption. In fact, it is often government which is needed to intervene and correct market failures like those in the stories.

Three tools have emerged for governments wishing to correct such negative externalities. These involve three fundamentally different approaches, some more effective than others. One involves direct government control. This is when governments intervene in a market in which negative externalities exist and try to make producers clean up their acts. They threaten producers with penalties and fines, and monitor industries to try and force firms to manufacture their products in a clean, efficient way. (this is like what the Europeans are doing to minimize their e-waste).

The next option also involves a large roll for the government: corrective taxes. Businesses that produce goods that end up polluting the environment (either through their production or consumption) can be taxed based on the amount of pollution they create. If creating more pollution means paying more taxes, the companies will find ways to produce in a more environmentally responsible manner, in order to keep their costs low and to maximize their profits.

The third method for externality reduction is also the most recently adopted. A market for pollution permits is set up, where a government actually gives all the companies in a polluting industry permits that allow them to pollute a certain amount. WHAT? The government’s allowing firms to pollute? Well, yes. The fact is, they’re going to do it anyway, they HAVE to in order to produce anything! The benefit of this system is that the government will only give each firm so many permits, and they’re not allowed to pollute beyond what their permits allow, UNLESS they go and buy more permits from producers that don’t need all theirs. This way, firms have an incentive to pollute less, because any permits they don’t use they can sell to other producers and make profits on those sales! Dirty firms have to buy more and more permits, clean firms get to sell those they don’t need… can you see where this is going? ALL FIRMS want to become clean firms in this scenario!

The three methods introduced above are being used to different degrees by different countries in various industries to try and mitigate the negative effects of some types of pollution and greenhouse gas emissions. Unfortunately, not nearly enough is yet being done, especially by some of the worlds largest economies (and thus, polluters), namely the United States, China, and India.

If our world is to avoid a fate like that of the tiny island of Nauru, where every last resource was exploited to the point where the island could no longer sustain life, then more must be done to reduce the spillover costs that accompany the production and consumption of so many of our precious goods.

I tell my econ students a story about how one day hundreds of years ago some smart guy decided to start calling products (you know, the stuff we consume), GOODS. From that day on humans would always associate consumption with something GOOD. Today, in an era where the goodness of consumption is offset by the evil of environmental destruction, more than a strong government hand is needed. Conservation and appreciation for the gifts of nature, not insofar as they can be exploited by industry, but left intact for the appreciation and welfare of society, both today’s generation and that of our grandchildren, must be fostered and encouraged among global citizens young and old.

Hopefully, this article and the stories you heard here will help you understand a little more about the economics of the environment, and help you become more educated about what can and should be done to correct the market failures that have led to the dire challenges faced by our world today.

A great website on environmental economics written by two economists WAY smarter than Mr. Welker can be found here: http://www.env-econ.net/

How does a growing Chinese middle class threaten duck populations in the American Midwest? Here’s the story:

As Prices Rise, Farmers Spurn Conservation Program – New York Times

“You can’t pay me NOT to farm this land!”

This is the view being expressed by more and more American farmers today. Since 1985 the US government has paid hundreds of thousands of farmers around $50 per acre of land per year to NOT grow food. In other words, if you were a farmer with 1,000 acres, you could earn $50,000 a year for not doing anything with it at all, just letting it sit idle.

What is the logic of such a program? In the mid-80′s food prices were so low that farmers working their tails off to cultivate and harvest their lands often found themselves losing money when they went to sell their crops. The traditional farming lifestyle was in jeopardy as farmers experienced year after year of economic losses. Improvements in farm equipment, along with the widespread use of chemical fertilizers, pesticides and herbicides had increased farm yields to levels never before achievable in human history. What increases productivity for all farmers, however, also increases total supply of crops, driving prices to historic lows. All this meant farmers could barely get by in the American heartland.

Enter the government:

…the Conservation Reserve was conceived as part of the 1985 Farm Bill. Participants bid to put their land in the program during special sign-ups, with the government selecting the acres most at risk environmentally. Average annual payments are $51 an acre. Contracts run for at least a decade and are nearly impossible to break — not that anyone wanted to until recently.

Things were great for the farmers. Output fell as millions of acres went into disuse, while farm incomes rose due to rising prices for their outputs and transfer payments from the American taxpayers. Farmers now had to work less to earn more money.

Today, however, farmers are putting millions of idle acres back into cultivation. They are choosing to work harder and farm more land in order to take advantage of the rising world food prices caused by the increasing demand for meat among the world’s emerging middle class and the rising price of grains due to the push to promote ethanol as a renewable energy.

The farmers’ behavior today is a perfect demonstration of the law of supply, which acknowledges the direct relationship between a product’s price and the quantity that producers will bring to market. There are actually two markets at work here: the market for cropland, and the market for wildlands. Farmers face a tradeoff in their decision of whether to farm their land or let it lay fallow. In 1985, the government made the decision that not enough land was lain fallow, so it subsidized farmers who set lands aside for conservation. Since subsidies are a determinant of supply, the supply of idle land increased while the supply of cultivated land decreased, driving up food prices.

In addition to the law of supply, this article also encompasses the concept of market failure. The Farm Bill of 1985 inadvertently corrected a market failure relating to “merit goods”, or those that create positive externalities or spillover benefits for society. In the case of farmland, the less land was used for farming, the healthier the wildlife populations on the now idle lands of the American Midwest. Hunters, environmentalists, and conservation groups had much to cheer about:

,,,hunters had more land to roam and more wildlife to seek out, with the Agriculture Department estimating that the duck population alone rose by two million; and environmentalists were pleased, too. No one disputes that there are real environmental benefits from the program, especially on land most prone to erosion.

At its peak the “Conservation Reserve”, as it was known, saw more than 36 million acres set aside for wildlife. Today, however, farmers are choosing to put this land back into cultivation.

Markets are complicated things. Markets do a fantastic job of assigning values to easily tradeable commodities like corn, soybeans, sunflower seed oil, and wheat, which happen to be some of the crops most commonly grown on the millions of acres set aside for conservation since 1985. What market fail to do, however, is to assign adequate values to the non-tradeable goods in our society. The biodiversity of a wild grassland, the health of a water fowl population, the carbon-sequestration capacity of a standing forest, and the joy a hunter gets from roaming a fenceless wild land.

As food prices continue to rise in response to the shift towards bio-fuels and the growing demand for meat among developing countries’ consumers, there will be more and more pressure for farmers in the industrialized world to take their lands out of conservation and put them into cultivation. This is not only a rich world phenomenon either. In Brazil, farmers are responding to rising sugar prices by cutting down ever growing chunks of the Amazon, one of the world’s last great rainforests, sometimes called “earth’s lungs” because of its ability to trap carbon from the atmosphere.

If balance between conservation and cultivation is to be achieved, it requires a market system that puts a tangible, tradeable value on the sometimes intangible “goods” relating to the environment. For now, a short-term solution might be a new Farm Bill that offers farmers a more substantial payment for keeping lands idle. Such an interventionist approach may stem the loss of wild lands, but does little to address the bigger problem of market failure underlying the degradation of the world’s remaining natural environments.

Motivated by a Tax, Irish Spurn Plastic Bags – New York Times

Here’s a textbook example of how government can use taxes to correct a market failure.

In 2002, Ireland passed a tax on plastic bags; customers who want them must now pay 33 cents per bag at the register. There was an advertising awareness campaign. And then something happened that was bigger than the sum of these parts.

Within weeks, plastic bag use dropped 94 percent. Within a year, nearly everyone had bought reusable cloth bags, keeping them in offices and in the backs of cars. Plastic bags were not outlawed, but carrying them became socially unacceptable — on a par with wearing a fur coat or not cleaning up after one’s dog.

A market failure existed; too many plastic bags were being used and discarded, creating negative externalities for society. A responsible government minister made it his mission to correct this market failure, and in the face of strong opposition from retailers. But guess what, it worked. Not only have they practically disappeared from the country’s retail stores, but their use has become a social taboo.

Why don’t more developed countries, where citizens can afford to care about the environment, place corrective taxes on plastic bags? Heck, why not use taxes to correct other market failures, too? How about a gas tax, for goodness sake?

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Environmental Economics: From the Answer Desk: Monitoring Cap and Trade

Towards the end of our last Micro unit, which was on Market Failure, SAS AP Econ student asked a good question in a comment on my blog post “Reducing negative externalitites – the European market for carbon emissions”

I forwarded Kevin’s question to the two professors who write the blog Environmental Economics. Their response to Kevin’s question is in the link above. Here’s what was posted on their blog last week:

Reader Jason Welker received the following question from a high school student (Kevin Yeh):

“It’s very interesting how this whole marketing pollution rights works. In this way the “commons” in the tragedy of the commons becomes privatized, and companies are forced to take responsibility for their pollution which is being dumped into the atmosphere.I do have one question, though, and that is how does one regulate the amount of pollution a factory dispenses into the air? How can the government be sure that a firm is not violating the law by dumping more than its licensed amount?”

My question: Why do Jason’s high school students ask better questions than my PhD students?

Anyway, I’m getting ready for a lecture on the EPA’s Acid Rain Program and I happened across this answer…

“Emissions monitoring and reporting systems are critical components of a successful program. Since the Program’s inception in 1995, the emissions data – continuously monitored by sources, verified and recorded by EPA, and posted for public review on the Internet – has been among the most complete and accurate ever collected by EPA. Unlike traditional emissions limitation programs, the Acid Rain Program requires an accounting of each ton of emissions from each regulated unit to determine compliance. The Acid Rain Program requires units to install Continuous Emissions Monitoring Systems (CEMS) to continuously measure and record emissions. In order to ensure accurate emissions monitoring and reporting, regulations specify equipment certification procedures, periodic quality assurance and quality control procedures, record keeping and reporting, and procedures for filling in missing data periods. All affected units are required to report hourly emissions on a quarterly basis to EPA’s tracking system. EPA invests substantial time and resources into assuring that both the monitoring and reporting of emissions are occurring properly and efficiently. Conservative “missing data” procedures help ensure that emissions are never understated. Real-time electronic auditing by EPA helps to ensure that emissions data are accurate, consistent, and complete.”

There you have it, Kevin! Looks like SAS Econ students are asking better, more relevant questions that Economics PhD students! Ahh… you guys make me proud!

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Carbon tax bill in the mail – Canada.com

…then we’d be spared the naive statements that appear in our media and out of the mouths of our citizens when a basic economic principle plays itself out in the market place.

In Quebec, the provincial government levied a carbon tax on energy producers:

When the provincial government imposed the country’s first carbon tax last fall, it wanted producers to pay.

But just as oil refiners have already done, Gaz Métro started passing on the cost of the carbon tax (to consumers) this month.

Big surprise, right? Only in a market in which demand is perfectly elastic would the entire burden of a tax be born by producers, since raising prices at all would mean loosing all their customers. Clearly, electricity is not such a market, and given the inelasticity of demand for a necessity such as electric power, chances are a big chunk of the “0.67 cents per cubic metre of natural gas” tax placed on utilities is being passed onto consumers.

In market economies, tax incidence is shared between producers and consumers. This of course, is the way it should be. If the price stays low and output remains high, no externality has been corrected and just as much greenhouse gas will be emitted as before the tax. In order to decrease output to a more socially optimal level, the tax should be passed on to consumers, but also born by producers in the form of lower profits. Despite this economic reality, consumers still aren’t happy about it:

“I don’t care how much it is, even if it’s just half a penny,” said Leonard, a Laval resident who called to complain about his gas bill. He spoke on condition that his last name not be used.

“They said consumers would not pay for this – and now here we are, paying for it.”

Poor old Leonard… never got to take an economics class in school! If only everyone had taken AP Econ in high school, naivety like this could be avoided! Ask ol’ Leonard if he’s stopped using electricity due to the higher price, and I bet you can guess his answer. Why? Inelastic demand.

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My Way News – Transit Panel Urges Gas Tax Increase

Looks like an increase in the gas tax might be on the horizon… but is it enough? Look at what the proponents of this tax want to do with the revenue:

Under the recommendation, the current tax of 18.4 cents per gallon for unleaded gasoline would be increased annually for five years – by anywhere from 5 cents to 8 cents each year – and then indexed to inflation afterward to help fix the infrastructure, expand public transit and highways as well as broaden railway and rural access, according to persons with direct knowledge of the report…

Okay, so driving places lots of strain on our physical infrastructure (i.e. roads, bridges, highways, etc.), surely we can consider that an externality that could be mitigated through a corrective tax. But does 40 cents over five years sound like enough to correct the negative externalities not identified here? What costs does America’s bad driving habit place on society beyond infrastructure degradation?

Thanks to Professor Haab for the link

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The Nano comes with its own moral dilemma. – By Anne Applebaum – Slate Magazine

Tata Motors of India recently launched the world’s cheapest automobile, the Nano.

“…meet the Nano, possibly the most significant new car of the decade. Small, cute, and snub-nosed, it fits four people and a duffel bag, has a single windshield wiper, travels at 60 mph, and it’s all yours for the princely sum of $2,500…”

Tata plans to build and sell 250,000 Nanos this year in India, spreading production to Africa, South America, and Southeast Asia. Clearly the company is targeting not the traditional auto markets of Europe and North America, rather the regions traditionally thought of as poor and thus not associated with auto sales.

What is the meaning of this “car for the masses”? At first glance, it looks like the perfect solution for bringing millions of the world’s poor (if not super-poor) closer to the dream of achieving a quality of life previously only accessible by the world’s middle class and rich. Great,  so what could possible be bad about fulfilling the dreams of so many of the world’s poor? The answer? Externalities…

“Though the small Nano uses less gasoline than many larger cars, the enormous potential numbers could mean an equally enormous environmental impact. Since it will be a long time before Nano drivers will be able to afford the $20,000-plus hybrids now on the market, let alone a Honda FCX Clarity, the prototype experimental hydrogen car thought to be worth as much as $10 million apiece, that means an exponential rise in carbon emissions as well as other kinds of pollutants. The United Nations’ top climate scientist, Indian economist Rajendra Pachauri—chair of the Intergovernmental Panel on Climate Change, which shared the Nobel Peace Prize with Al Gore—has said he is already “having nightmares” about precisely this scenario.”

Herein lies the moral dilemma of the Nano: where does society’s desire to improve the lot of the world’s poor come into conflict with society’s desire to to improve the environment and minimize the impact global warming?

What do you think? Do the social benefits of a $2,500 car exceed the social costs it will likely impose? Does the Nano’s $2,500 price incorporate the full costs that its existence places on society and the environment? Should we jump for joy at the thought of millions upon millions of the world’s poor finally having access to the convenience of automobile transport? Or should we pause with uncertainty to contemplate the effect on the environment and the social costs that millions of cheap cars will impose on the world?

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Matt Rothschild of Progressive Magazine concludes that global warming is one “giant market failure”, and argues that US president George W. Bush is making it too hard for regulators in the country that is the world’s largest emitter of greenhouse gases to impose limits on pollution.

Among the externalities caused by the emission of greenhouse gases that Rothschild points out:

• Rising sea levels
• Arctic free of ice
• Draughts  in Africa

 "Global warming is a giant market failure" [1:28m]: Play Now | Play in Popup | Download

Discussion questions:

1. Is Rothchild’s understanding of global warming as a market failure correct in an economic sense?
2. Is imposing new “limits on pollution” the best way achieve a long-term reduction in the emission of greenhouse gases?
3. What alternatives to direct government controls over firms’ emissions does the Bush administration have that may make use of “markets” to correct this “giant market failure”?

Michael Munger, Bosses Don’t Wear Bunny Slippers, If Markets Are So Great, Why Are There Firms: Library of Economics and Liberty

The other day when we introduced our unit on market failure, we began by revisiting the concept of free markets as mechanisms for allocating scarce resources efficiently. As I was reading blogs tonight, I stumbled upon this blog post by Michael Munger, professor of political economy at Duke University, where he shares an anecdote he uses when introducing the allocating power of markets through the price mechanism:

When I teach political economy, I start with the neoclassical theory of consumption, and then cover production. And I show students how miraculous is it that the actions of millions of people who have never met can be directed by prices. Resources move toward their highest valued use, and consumption goods are delivered to the consumers who want them.

For example, the United States promoted ethanol as an auto fuel. This sharply increased the price of corn worldwide. As Brazilian reporter Kieran Gartlan put it: “Higher prices are leading Brazilian farmers to plant more second crop corn this year, and the country’s modest corn exports are expected to expand [from 42 million tonnes to 48 million tonnes, an increase of 230 million bushels.]” (DTN, March 2, 2007, emphasis mine).

No one directed the Brazilian farmers to shift to corn production. The article puts it perfectly: “Higher prices are leading farmers….” The leadership comes from the prices themselves! The farmers may have had no idea why the price of corn had increased, to $4.00 per bushel. (After all, Brazil uses sugar, not corn, to produce its ethanol.) But Brazilian corn production increased within a year, by nearly 15%. No one made the farmers switch; they made choices. Other corn producers, in Argentina, Mexico, and several African countries, followed suit. No one talked about it, no one gave any orders; prices led them.

The reason I post this excerpt from professor Munger’s blog now is that it serves as a great response to a student who on the first day of our market failure class posited that perhaps the government could do a better job of deciding what goods and services and how much of them should be produced in an economy.

Yes, markets fail, and for many reasons: a concentration of power among a few large firms, an underallocation of resources towards goods that have spillover benefits, the over-provision of goods that have spillover costs, the failure of the market to provide public goods: these are examples of how market fail.

But when markets work, they really work! The efficiency of resource allocation that results from free, competitive, markets is unrivaled by any central planning agency. Munger’s example above is a simple illustration of this allocative power of markets and prices.

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Greg Mankiw’s Blog: The Pigou Club Manifesto

Here’s a good question to bring up around the dinner table with mom and dad tonight: “When is more taxes good?” Most individuals in society despise taxes; what is it the cynics say? “The only things guaranteed in life are death and taxes.” Clearly, the thought of giving money to the government is as miserable for some as the thought of dying!

But when might more taxes be good taxes? The answer, as you may have guessed, has to do with the concept of negative externalities and the idea that a tax may be used to correct a market failure of too many resources being allocated towards a particular product. One such product towards which too many resources have been allocated in the last several decades is gasoline; that’s right petroleum gas, the life blood of our beloved automobiles, the symbols of our very freedom and prosperity we cherish so much. How do we know too many resources have gone towards the production of gasoline? Simple, there’s too much of it and it’s too cheap. Evidence? Just look around:

• Congested roads
• Urban smog
• Auto accident fatalities
• Shortage of parking spaces in most cities
• Noise pollution
• Sprawling road systems that ugly the landscape
• Global warming

All of the above ills in some way are the result of cheap gasoline. The market failure here is simple: too much gas has been produced and it sells for too cheaply, hence, lots of people drive lots of huge, gas-guzzling SUVs, trucks, vans, sports cars, luxury sedans, Hummers, and not enough small, economical, fuel-efficient automobiles that would put way less a strain on our urban and natural environments.

So what do we do now to fix this problem? Should be dismantle all the oil refineries, shut down the gas stations, and blow up the pipelines that facilitate the production of gasoline? Well, that would be one option, although it’s not ideal. Another might be to require that all auto makers achieve a certain level of fuel-efficiency among their automobiles. That’s what the US government has done by adopting the “Corporate Average Fuel Economy” (CAFE) standards. This sort of direct control creates market distortions of its own, however. One economist has said, “the CAFE standard was a failure and said it was like trying to fight obesity by requiring tailors to make only small-sized clothes”

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Tighter European limits set to push up price of carbon emissions – Times Online

When it comes to correcting the market failure of negative externalities, governments have several options. The most interventionist approaches may involve placing strict limits on the amount of a pollutant firms are allowed to emit and fining them for exceeding this limit, taxing firms that pollute in order to increase their costs and decrease market supply, reducing output and increasing price closer to a socially optimal level, or simply banning the production and consumption of goods whose existence places excessive spillover costs on society.

Such interventionist approaches to externality reduction tend to require a complex bureaucracy to administer, monitor, execute and enforce. The government may not be able to determine the appropriate level of a tax on a polluter if it can’t determine the exact level of the externalized costs placed on society; the government cannot always check up on every producer in the economy to determine just exactly how much pollution each factory’s producing, and then levying a fine on excessive polluters again raises the question of how high should a penalty be?

Because of the complexities involved in the interventionist approaches above, economists have recently promoted and the worlds’ governments have begun adopting a market-based approach to reducing negative externalities, involving the creation of a whole new market: one in which the right to pollute is bought and sold by firms. This may sound crazy at first, but here’s a basic summary of how these markets work:

• A government or international agency decides on the acceptable amount of pollution in a particular region and issues permits that firms can purchase giving them the right to pollute. Each permit will allow a certain amount of pollution. The total supply of permits is perfectly inelastic since it is decided by the government agency.
• The demand for pollution permits is downward sloping. At high prices, firms will either stop polluting or pollute less by acquiring pollution-abatement equipment, which is more attractive when the rights are more expensive. If the “cost of pollution” is cheap, then firms will chose to buy permits rather than acquiring expensive abatement equipment or upgrading to “greener” technology.
• In the market for pollution permits, the “price to pollute” will be determined by the downward sloping demand among firms for pollution permits and the perfectly inelastic supply of permits determined by the number issued by the government. If the price of permits is too low to make firms bear the full environmental and social costs of their production, the government can reduce the supply thus increase the price and decrease the quantity of pollution permits demanded, reducing the negative externalities of pollution as firms will shift to greener production techniques.

There are several advantages to this system over direct government controls:

• It reduces society’s costs because pollution rights can be bought and sold. Some firms will find it cheaper to buy the rights than to acquire abatement equipment; other firms can sell their rights because they may be able to reduce pollution at a lower cost. The incentive for all firms is to reduce their own pollution and sell the permits they no longer need, adding to the profits of “green firms”.
• Conservation groups and  individuals can buy permits as  well as producers. If conservation or individuals wish to make it more expensive for firms to pollute, they can buy permits and hold them. This drives up the price of remaining rights, further encouraging polluters to reduce emissions.
• The revenue from the sale of pollution rights could be used to improve the environment or subsidies more environmentally friendly methods of production.
• The rising cost of pollution rights should lead to improved pollution-control techniques.

In the article above, we see how the creation of a market for carbon pollution permits in Europe evolved from a fledgling, ineffective experiment in market-based externality reduction a few years ago to a major market where billions of dollars worth of carbon permits are exchanged each day between firms, all of which have incentives to continually reduce their level of carbon emissions so as to minimize their costs and perhaps even earn revenue through the sale of unneeded permits.

The first phase (of the carbon permit market) was launched in 2005 but was widely dismissed as a failure, primarily because too many permits were granted by member states to individual polluters, leading to a collapse in market prices to as little as €1 (74p) per tonne. The slide undermined the principle of the scheme – to make carbon emissions a meaningful cost for big polluters, thereby encouraging reductions.

The key difference in the second phase is a reduction of between 5 per cent and 10 per cent in the emissions permits granted. Mr Marcu said that he expected the tougher regime to “start delivering some substantive reductions” in carbon emissions.

City analysts believe that it will lead to a big increase in the market price of carbon. Deutsche Bank expects forward prices to rise from the present level of about €23 a tonne to €35. UBS has predicted a rise to €30 a tonne.

35 euros per ton of carbon may not sound like a lot, until you consider how many millions of tons of carbon are emitted by the big factories of Europe each year. In fact, when we realize the size of this market at $100 billion, we then begin to grasp just how significant such a market can be in reducing greenhouse gas emissions. That means that firms are spending $100 billion for the right to pollute!

Just imagine, if you were a manager of a firm that was polluting heavily, the more expensive these permits get, the higher your average costs of production get, the less competitive you become with firms who have taken steps to clean up their production. Not only do you not have to buy as many permits once you start cleaning up, but you actually start earning revenue by selling the permits you no longer need!

A market for externality permits minimizes the role the government must play in managing the production and emission practices of the economies big polluters. Furthermore, if the permits are auctioned off from the beginning, billions can earned in revenue for the government, which in theory could be used to subsidize the research and development of pollution abatement technologies and “green energies” like wind and solar power.

While it still may seem weird that governments are giving firms the right to pollute, the logic of such a plan makes sense once the picture is clear. Markets work, even when they’re being used to correct a market failure.

Discussion questions:

1. What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?
2. Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?
3. What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

Environmental Economics: What is the Coase Theorem, really?

John Whitehead at Environmental Economics and I have something in common; we both struggle to clearly explain the Coase Theorem. This is a minor topic in AP and IB Economics courses, part of the Market Failure and Externalities units. Basically, the Coase Theorem presents individuals involved in a property rights dispute a market based mechanism for correcting the existence of an externality, as opposed to turning to the government or the legal system. Whitehead’s article linked here goes into a bit more depth than the typical principles text book, but clarifies some of the misconceptions and shortcomings of the basic theorem introduced in those texts.

In all likelihood, high school econ students will never need to know more than the basic version of the Coase Theorem, so this article is most useful for students (or teachers) who want to extend their understanding beyond the basic level. But while we’re on the topic, I thought I’d share my own method for illustrating Coase. This represents the basic version, but I think it illustrates the concept more clearly than the typical example from a text. I tell them a story, here it is:

When I was a kid we lived in this little yellow house outside of Minneapolis, where summers are brutally hot and humid. Our next door neighbor had a huge old oak tree in his yard with branches that spread out over our yard and provided us with shade for playing outside on hot summer days. One day, after a bad lightening storm, our neighbor became afraid that this huge oak tree might someday get struck by lightening and fall on his house, so he decided to cut it down.

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