Thursday, March 22, 2007

(Mis)understanding the externality

The concept of externality is again easily overplayed.

When you and I transact and somebody else gets affected (in a good or bad way) without any compensation, externality arises. That is more or less the standard definition in almost all textbooks. That definition is dangerous. Because, come to think of it, almost every transaction therefore causes externality.

The second, and even worse, misunderstanding is that in the presence of externality, you should call for government intervention. This is a fallacy. Believe me, if you don’t like me smoking next to you, we can work it out by you pay me not to smoke, or I pay you to suffer. We don’t need the government to ‘internalize that externality’. But let’s do some simple arithmetic to make this argument clear.

Suppose A pollutes and B is harmed. If B would pay Rp XXX to avoid such harm, and if A would have to incur an additional cost of Rp YYY to eliminate the pollution, then if XXX is less than YYY, the government should do nothing.

So if instead XXX is greater than YYY, the government should do something, you say? It depends. If XXX is in fact greater than YYY, then B should have offered some money to A in the first place, so as the latter did not pollute, don’t you think? But why hasn’t B made a bargain with A? Because, that might have required some costly process (think about tiring negotiation or time costs or lawyer’s fee, for an example). In other words, there is a non-zero transaction cost, say Rp ZZZ. So, here, it must be the case that ZZZ > (XXX – YYY). Then what is the answer to the question ‘should the government do something?’ Well, remember, intervention can be costly, too. First, the government should calculate XXX. Next it should also discover YYY. Finally, it should administer the scheme (costly, too) – whatever it is. If the total cost of undertaking these three tasks is WWW, then only when WWW < (XXX – YYY), the government intervention is justified.

More on alternative solutions later.

Note: Of course I owe this argument to Coase (1960, The Problem of Social Cost, The Journal of Law and Economics)


  1. "But why hasn’t B made a bargain with A?"

    maybe i'm missing something here, but i thought the onus is always on A, the one-who-started-it, to solve the problem.

  2. I think coase theorem only applied iff there is additive utility function. With this type of utility function, individual can trade away the distributive part of the utility function. That's why the argument -that regardless who has the property right is the allocation would be optimum- is true. However, if this assumption is violated, the argument is not hold anymore. The allocation is indeed affected by the who has the property right on the goods in question. (cmiiw)

    Since the allocation depends on the who has the property right, if we insists to use coase theorem, we argue who has the property right. Again in this case, you need the government to decide who has the property right.

    Hence, In either case, pareto tax or coase, you still need the government, don't you??

    To compare which one is better, again, we need to carefully calculate the cost bargaining process, the cost of accruing the property right, cost of gov't intervention to use pareto tax or to allocate the property right.

    My point is , in normal situation, it is possible that the gov't intervention is better than coase theorem. For me, the optimal allocation under coase theorem is just a theoritical exercise.( come on..when will the additive and separable assumption be valid in the real world)


  3. And there comes the common prejudice, Tirta. What makes you think 'the onus is always on A'? What if I say B is harming A's business by demanding the latter to reduce or halt its production?

    In that linked course material, I also said, "When I decide to play my stereo in the middle of the night, I guess I am imposing an externality on my neighbor next door. The problem should've been solved had I asked for a permission beforehand, and had he granted me. But note: When the neighbor decides to go to bed, while I am still listening to my stereo, and he demands a right to sleep in peace, he is imposing an externality on me, no?"

  4. Restu, first off, in this case, it will not be useful to talk about utility function. What is of more concern is the cost function -- the cost of eliminating the pollution in the part of A and the cost of avoiding or accepting the pollution in the part of B. There has been controversy over whether or not the cost function should be additively separable, too. But as Coelho puts it (AER, 1975), Coase Theorem holds no matter what the cost function is.

    Second, we don't need to know who holds the property rights. All we need is that somebody has it. No, you don't need the government to decide who is that somebody. But yes, you need the government to make sure that the right is respected -- just in case.

    Third, Coase Theorem (I think we should be talking about Coase Paper, not just that theorem) is not an antonym of government intervention! In fact it, among others, explain when you actually have a justification for the government to chip in.

  5. not really sure, but i guess we can at least start with the principle of liberty: you can do as you wish as long as you don't disturb anyone. surely doing nothing (the null condition) can't be on the same plane with doing something, otherwise i can just smack you in the face and argue that your anger for being punched is just another externality imposed to my wish to hit you, no?

  6. Aco said:
    "...first off, in this case, it will not be useful to talk about utility function..."

    Aco, I think we could not just ignore the utility function here. I think there are two effect in case of transfer in coase theorem.
    1. The change of utility function due to the increase/decrase of specific good. (in smoking case, I decrease my smoking consumption. Doesn't it affect my utility).
    2 The change of the budfget constraint due to transfer between individual. Since there are direct and indirect effect of utility function, why should not we take into account this utility function into analysis?

    Since it affects the utility function with different possible functional form, the results sould also depends on the functional form of the utility function.

    ... we don't need to know who holds the property rights. All we need is that somebody has it. No, you don't need the government to decide who is that somebody..."

    Again, I think by taking into account the standard utility function of individual. It is does matter who has the property right. (unless the util is separable -cross derivative is zero)

    Furthermore, we all know that the coase theorem is the matter of bargaining between the two individual. Regardless who has the property right,they still have to bargain each other to determine the level of consumption (that produced polution), thus the change of utility function). Therefore, I think in order to get the solution, we should use the nash bargaining problem between these two individual.

    By doing this method for two possible solution (either A or B has the property right) , I think who-has-the-property-right does matter to final utility function of both agents.

    I do not know whether the coase paper alo take into account the util of individual and the solution using nash bargaining process. May be you could tell me.

    cmiiw, imo. (thanks anyway for the discussion)

  7. mmm, just came up to me that if i punch you directly, it may not be, by definition, an externality. so let's say this time i smack your partner, and make the very reasonable assumption that me hitting your partner is affecting you. all sorts of issues between me and your partner can be safely put aside momentarily, as i'm keen to know how you would reason about me insisting that your anger for the punching of your partner is just another externality you want to impose on me.

  8. addendum :

    You are totally correct about the coase theorem. It is also already in our standard micro text book.

    What I said in previous comments, could be the critique to results of coase theorem.

    Thx anyway..

  9. Tirta, you're welcome to smack my partner. But how about you pay me first (or afterward) some handsome money? That's one. Or, another option, how about if I pay you some money for not smacking my partner?

    Restu, I'm not ignoring utility in the picture, I just believe in order to address your concern it is better to focus on the cost function rather than utility function. Anyway, we can exchange proofs if you like -- I'm afraid the Manager would scold me if we bring too much technicalities and jargons into the Café Email me at patunru @ gmail . com

  10. surely i prefer the second option, which is a darn good idea to easily make money: how much are you willing to pay? :)

    anyway, i have to admit that i'm not really sure where i'm going with this. but my hunch is that externality-based explanations may not be appropriate here. one does not refrain from randomly smacking others because of any externality calculations, but because it feels wrong. there are burgeoning studies spanning biology, psychology, and neuroscience, showing that morality, after thousands of years of philosophical musings, may be less dependant on reason, and much much more on emotion.

    again, i'm not an economist, so apology should i have taken this out of context.

  11. Restu,
    In a two-person bargaining, the agreed post-negotiation price should have reflected distributional (and any other) concerns of bargaining individuals, despite the functional forms of the utility function.

    This is the point of Coase theorem: When property rights are well-defined, outcomes coming out of negotiations are efficient. In your case, the property rights -- in this case, to not be smacked -- is well-defined and is even protected by the criminal code.

    Coase's point is that often externalities come about simply because the property rights are not well defined. Once you define these rights, negotiations without government intervention can solve the problem of externalities efficiently.

  12. Buyat Bay case, for example, could be beyond externalities.

    Newmont is being sued by Buyat Bay residents represented by the NGOs. The NGOs are quite supported by the govt unfortunately.

    On the other side, seeing there's no good evidence of pollution presented by the NGOs, local scientists conducted some experiments and seminars and concluded that there's no evidence of pollution in the bay area. Then presented the evidence as expert witness' contribution.

    The Newmont gold mine here is seen as a local asset/property. If Newmont lost, it will impact the whole area of Minahasa economically, not just the Buyat Bay residents (who are migrants from other area). Even the contribution to central govt.

    So many parties involved: Newmont, Buyat residents/NGO, Central govt/Local govt, Local scientists. Could be beyond externalities.

  13. All, this is getting more interesting. But I apologize I can´t really answer in length, cause I just arrived in Munich. I´ll try to sneak out from the conference, if I can :) Arya is right, I was going to the law issue (protection of property rights). But in short, Tirta, you would have to be really strong and frightening to me to make my willingness to pay you nonzero, nonnegative :) (God, this German keyboard is killing me)

  14. Dear Tirta and others, sorry for the delay. I was about to post a new entry just talking about the law aspect of Coasian economics, but I guess I'd just refer you to this nice piece by David Friedman. I hope it helps better.