Negative Externalities and the Tragedy of the Commons

Externalities occur when a transaction between two parties affects a third party who is not involved in the transaction.
A negative externality imposes costs on a third party who is not part of the transaction. Externalities can create problems.

Economic activity can lead to pollution of air, water, and land.
The three biggest sources of pollution are:
- Road transportation
- Electricity generation
- Industrial processes
Pollution exists because economic activity creates costs for other people that are not considered by the buyers or sellers when making decisions.

The world faces a Global Energy Challenge (GEC) that requires countries to balance inexpensive and reliable energy, clean air, and limiting damages from climate change.
Key facts to illuminate the GEC:
- Energy sources (coal, natural gas, nuclear, solar, wind, and petroleum) differ in price, effects on local air pollution, and climate change impacts.
- Combustion of fossil fuels is a primary source of conventional or local air pollution, including particulate matter (PM), carbon monoxide, ozone, nitrogen dioxide, and sulfur dioxide.

A private cost of production is borne by the producer.
The marginal private cost (MC) is the private cost of producing one more unit of a good or service.
An external cost of production is borne by others (third parties).
The marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.
The marginal social cost (MSC) is the total cost incurred by everyone, including the producer and those affected by the external cost.
- MSC = marginal\ private\ cost + marginal\ external\ cost
Marginal private cost, marginal external cost, and marginal social cost increase with output.

The amount of pollution created depends on the equilibrium quantity of the good produced.
The quantity produced is where the marginal private cost (MC) equals demand (D=MSB, Marginal Social Benefit).
In an unregulated market, external costs are not considered in transactions, leading to an inefficient quantity of the good being produced (too much).

Externalities can arise due to the absence of property rights, which are legally established titles to the ownership, use, and disposal of factors of production and goods/services.
The establishment of property rights can create an efficient outcome because the producer bears all the costs.
With property rights:
- PRICE = MSC = MSB

If:
- Property rights exist
- A small number of parties are involved
- Transactions costs are low,
Then private transactions are efficient, and parties take externalities into account. The outcome is independent of who initially has the property rights.
The Coase solution works if transaction costs are low. When a large number of people are involved, transaction costs are too high, and the Coase solution doesn’t work, requiring government intervention.

Government solutions when there are external costs:
- Taxes (Emission Charges)
- Marketable Pollution Permits (“Cap-and-Trade”)
- Tort Law

Marginal\ Private\ Cost + TAX = Marginal\ Social\ Cost
A tax equal to the external cost is called a Pigovian tax.
A “pollution” tax equal to the marginal external cost creates an efficient outcome (MSC = MSB).
With emission charges, the government sets a price per unit of pollution.

Each firm is assigned a permitted amount of pollution, and firms can trade permits in a market.
The market price of a permit confronts polluters with the full costs of their actions and leads to an efficient outcome.
Firms can pollute more by paying someone else to pollute less.

Third parties can sue firms in a court of law if they can prove that they are causing harm.
The court compensates individuals for costs they incur.
The legal system confronts polluters with the marginal external costs of their actions, leading to a more efficient outcome.

Coase Theorem: If low transaction costs, markets solve the problem by rearranging property rights to internalize the externality.
Pigouvian Tax: Government creates Tax = External Cost.
Marketable Permits (“Cap and Trade”): Set “Pollution Cap”, Polluters Buy/Sell Permits.
Tort Law: Legal Judgement = External Cost (or more).

Common resources are overused because people have no incentive to conserve or use them sustainably. Examples include grazing land and overfishing.

Renewable Resources: Replenishes itself by birth and growth of the population.
Sustainable Catch: Quantity that can be used each year without depleting the stock.
As the stock increases, the sustainable catch increases.
Sustainable Use: Only using a sustainable amount.
If the catch exceeds the sustainable catch, the fish stock diminishes.

By converting the common resource to private property, producers face the full social cost.
The resource is used efficiently.
The private marginal costs become equal to the marginal social costs.

Setting a production quota at the efficient quantity causes the resource to be used efficiently.
However, there is an incentive to overproduce if a producer cheats.

Examples include rules for lobster fishing, such as size limits and protection of egg-bearing females.

How much tax should be collected to make MSC = MSB?
What price per unit should be charged for emissions?
How many marketable permits should be allowed?
How do you know when and how to change these over time as market conditions change?

Costs (or benefits) to third parties not involved in a transaction; A by-product of economic activity.
If only private costs are considered, the market can produce too much of a good: MSC > MSB; i.e., pollution.
We want MSC (private cost + externality) = MSB
Coase: If property rights exist and transaction costs are low, the market will solve the problem - parties make an agreement.
If transactions costs are high, the market can’t solve, then Public Choices Government Solutions: Taxes, Emission Fees, Marketable Permits, Torts (Courts)
Tragedy of the Commons: Overuse of a common resource because there are no incentives to conserve; Solutions: Property Rights, Quotas, Rules, or Laws