Negative Externalities and the Coase Theorem


Standard economic theory states that any voluntary exchange must be beneficial to both parties in the trade because no one would ever knowingly and voluntarily enter into a trade that somehow left them worse off.  However, economic activities can cause additional effects on third parties not directly involved in the exchange.  These effects are called externalities, because they are not borne by the people making the decision about the activity.  They are also known as spill-over effects, and they can be negative (e.g., health problems caused by pollution from a factory), or positive (honey bees kept for honey that also pollinate crops).

When externalities are present, market prices fail to correctly signal the complete cost of goods or services, resulting in a misallocation of resources.  In particular,  negative externalities are a concern because they result in the market producing costs that subtract from social welfare.  The following video explains the concept of negative externalities in micro-economic terms.

In Khan’s view, which corresponds to the standard neoclassical understanding of externalities, the solution to problems of external cost is to internalize the costs.  In Khan’s example, simply raising the price of plastic bags by charging the bag producers (or consumers, it doesn’t matter) for social costs such as cleaning up litter will decrease plastic bag production and free up resources (capital, energy, material, labor) to produce other goods that people ultimately find more satisfying.

If plastic bags kill animals (or people), the economist asks “What are consumers willing to trade (in money) for these lost lives?”

Simply find that number, and adjust the price of bags accordingly until the enjoyment from the last bag produced (the marginal bag) is equivalent to the distress (i.e., cost) of the last (marginal) life loss.

This simplistic view of internalization is not particularly concerned with who is killed, or who benefits (e.g., from plastic bags).  These are problems of  distribution (e.g., of profits, or other benefits) whereas the primary concern in he Khan video is allocation (how much to produce of which goods).  Internalization of external costs solves the allocation problem, but could still result in problems of distributional injustices.

“Solutions” to Negative Externalities

The following video reveals three theoretical ways to address the allocation problem of externalities, including: 1) taxation, 2) regulation, and 3) property rights.  Taxation places the financial burden of external costs on the producer.  Regulation can be in the form of requiring a technological fix or  limiting the quantity of goods and/or pollution produced.  The property rights solution is also known as the Coase Theorem, developed by Nobel Prize winner Ronald Coase.  The theory states that optimal allocation of resources is achievable without any government intervention, provided that transaction costs are low and property rights are pre-determined.  In this case, Coase claims that the polluting and damaged parties will negotiate a transfer of payments between them to either accept damage or reduce pollution on the basis of which was more profitable.

The Coase Theorem does not consider whether the Farmer or the Fishermen drive the harder bargain.  That is, so long as profits (or enjoyment) as a whole are optimized, then the Coase Theorem is satisfied.  But what if property rights are assigned to the Farmer?  Suppose the Farmer would profit 10 (dollars, or whatever) from fertilization of the corn field.  The fisherman enjoy fishing so much that they’d be willing to pay 15 to fish.  According to Coase, the Fishermen complain to the Farmer that the fertilizer is killing fish, but the Farmer says that without the fertilizer, his profits would be reduced to 10.  So the Fisherman offer to pay 6 to the Farmer to persuade him to stop using the fertilizer.

The Farmer’s profits are now 11 (5 from unfertilized corn farming and 6 from payments received from Fishermen) and the Fisherman pay only 6 for something that they enjoy as much as 15.  Everyone is better off.

But what if the Farmer drives a hard bargain?  Maybe he thinks, “If these crazy, rich Fishermen will pay 6, then they’ll probably pay 7, or 8.”  Even in the case of ideal conditions for Coasian bargaining, there is nothing to guarantee that the moral implications of the externality will be resolved, partly because Coase is concerned only with the optimal allocation of resources and not the optimal distribution of benefits (or profits) resulting from the economic activity.

When the Farmer controls the property rights, and is under no obligation to sell them, the Farmer-Fishermen interactions can be modeled as The Dictator Game, wherein the Farmer can capture all the benefits of fishing for himself!

Aside from this distributional issue, and the moral problems that it creates, other obstacles often prevent Coasian bargaining.  Coase himself admits that in reality, transaction costs are rarely low enough to allow for efficient bargaining.  Moreover, direct causality is often difficult to prove.

Imagine the Farmer claiming, “My fertilizer doesn’t kill fish.  The fish love my fertilizer.”

If the Fishermen don’t realize what is killing fish, then how would they know to approach the Farmer with an offer?

Or, what if the Fishermen value the fish highly, but simply have no money to pay?  Perhaps instead of the recreational fishermen represented in the video, they are subsistence fishermen who use the lake to feed themselves.  To the Fishermen, the fish are priceless.  But a willingness to pay does not equate to an ability to pay?

The External Costs of Climate Change

Richard Tol wrote in his 2009 paper entitled, The Economic Impact of Climate Change, that “Climate change is the mother of all externalities: larger, more complex, and more uncertain than any other environmental problem”.  The reason for this complexity is that emissions of green-house gases from any geographical location on the Earth’s surface travel to the upper atmosphere and play a role in affecting climate globally.  Hence, the impact of any particular emission of greenhouse gases (GHGs) is not realized solely at its source, either individual or geographical; impacts are dispersed to other actors and regions of the Earth.  Furthermore, GHG emissions are responsible for a myriad of impacts including changes to Earth’s climate system, manifested in events such as drought, floods, sea-level rise, temperature changes, extinction of species, and spread of disease.

This video draws attention to the fact that climate change will adversely impact people that are unable to protect themselves and did little or nothing to create the problem.

The moral complexities surrounding global climate change beg the ethical questions, “What are the developed world’s obligations to the developing countries?  And should the developed countries risk their own sense of well-being to meet these obligations?”

Lastly, economists might ask “If property rights were well-defined, could Coaseian bargaining resolve the problem of global climate change?”

The Externalities Game (TEG)

The following video will relate the above concepts of negative externalities and the Coase Theorem to TEG. In TEG you will be able to test Coase’s theory directly with your classmates.

Introduction to Social Ethics

The dominant ideas in moral philosophy emerged from the Enlightenment, which was an intellectual movement during the mid-17th to late 18th century that followed the Renaissance and preceded the Industrial Revolution in Western Europe.  The scientists and mathematicians of the Renaissance period were heavily influenced by the careful observations of nature perfected by the artists of the time.  In the case of da Vinci (1452–1519), there seems to be little distinction between art, science, and engineering, all of which could eventually be wrapped up in the single term technology — meaning the study of technique.

It may be that the realism evident in the cultural movement of the Renaissance inspired an empiricism in science, as best exemplified by Bacon (1561–1626).  However, the scientists and mathematicians of the early Enlightenment, such as Descartes (1596–1650) , Newton (1642-1727), and Leibniz (1646–1716), shifted their attention away from art and towards philosophy.  They saw science as a structured approach to discovery of the immutable and generalizable laws that govern Nature, as observed in the interactions between energy and physical objects, including the orbit of planets around the sun and the behavior of light.  It is this tradition of natural philosophy that gives the modern “Doctor of Philosophy” its title, despite the fact that graduates from modern Ph.D. programs in the physical and natural sciences typically never study the modern discipline of Philosophy at all.

Following the intellectual trajectory established by Copernicus (1473-1543) and Galileo (1564-1642), Newton used the natural laboratory of the solar system as the empirical basis for his Philosophiae Naturalis Principia Mathematica, in which he described the laws of motion that governed the orbit of the planets around the sun and (by extension) the interactions between all other ideal bodies.  In the near perfect vacuum of outer space, where objects act upon one another at a distance, Newton could study without the distraction of non-idealities (like friction, or drag) that likely led Aristotle (384-322 B.C.) to believe that heavier objects fall faster than light objects.

Thus, Newton established the model of modern scientific investigation adopted during the Industrial Revolution — investigation of idealized particles by a detached scientific observer, testing mathematical descriptions of observable phenomenon — and established  physical science (i.e., physics) as increasingly independent from metaphysics.  But the Enlightment was also a celebration of the political and intellectual freedom of the individual (“Knowledge is power” – Bacon) as the emphasis shifted from knowledge of God to knowledge of self.  Philosophers like Locke (1632-1704, England), Voltaire (1694-1798, France), Smith (1723-1790, Scotland), and Kant (1724-1804, Prussia)  departed from the empirical Newtonian topics of study and established philosophy as a separate discipline, even though they were deeply influenced by Newtonian successes.  In fact, the Enlightenment was an especially productive period in the establishment of new domains of study.  The Stanford Encyclopedia of Philosophy notes:

The commitment to careful observation and description of phenomena as the starting point of science, and then the success at explaining and accounting for observed phenomena through the method of induction, naturally leads to the development of new sciences for new domains in the Enlightenment. Many of the human and social sciences have their origins in the eighteenth century, in the context of the Enlightenment (e.g., history, anthropology, aesthetics, psychology, economics, even sociology), though most are only formally established as autonomous disciplines in universities later.

Thus, all the sciences of the Enlightenment were either unconsciously or consciously imitative of physics in the sense that they adopted reductionist approaches to seek generalizable principles.  In moral philosophy and the social sciences (including economics), the natural locus of study was the individual as an analogue to the Newtonian particle.

One  of the major philosophical crises of the Enlightenment was the nature of free will.  From the Stanford Encyclopedia again:

Newton’s success early in the Enlightenment of subsuming the phenomena of nature under universal laws of motion, expressed in simple mathematical formulae, encourages the conception of nature as a very complicated machine, whose parts are material and whose motions and properties are fully accounted for by deterministic causal laws.

Philosophers such as Hume (1711-1776) who  sought to “establish the basic laws that govern the elements of the human mind in its operations” (ibid) explicitly adopted Newtonian mechanics as a metaphor for explaining human behavior — a view that proved remarkably persistent.

When real, observable human behavior failed to correspond to the idealized models developed by the philosophers, psychologists, and economists of the resulting Industrial Revolution, more often than not the failure was ascribed to the humans — not the theories.  These behavioral failures could be medical, psychological, cognitive, or moral, but the deviation between normative ideas of what behavior should be and descriptive accounts of real behavior were nevertheless consistently attributed  to some deviance in the individual exhibiting the behavior.

In this view, a moral individual ascribes to a consistent set of ideal principles, regardless of the behavior others.  According to Kant, to do less would be irrational.  While there may still be room to argue about which are the correct moral principles, the Enlightenment approach to moral philosophy holds that there must be laws of moral reason that are generalizable, universally applicable, and discoverable from some foundational principles.

Nevertheless, evidence that people do not behave as rationalistic and individualistic atoms — even in an ideal sense — keeps accumulating.  This series of videos either discusses or re-creates a series of experiments that are now several decades old.

The first is the Asch Conformity Experiment, which shows that individual reason is subject to distortions resulting from interaction with others in a group setting.

The next video illustrates the Bystander Effect, in which the moral actions of an individual seemingly depend on the expectations of a group, rather than a personal sense of right and wrong.

These three videos document the Milgram Experiment, in which subjects conform to the expectations of authority, despite the misgivings of their own conscience.

Lastly, the most infamous of these experiments may be the Stanford Prison Experiment, in which college students randomly assigned to the role of “guard” or “prisoner” adopted extreme persona that aligned with their assigned characters.

Both the Prison Experiment and more recent abuses at Abu Ghraib prison in Iraq call into question the usual explanation — what we might call the “Bad Apple Theory“.   According to this explanation, just one or a few deviant individuals can spoil the behavior of the entire group.

While there certainly may be immoral behaviors that are stronger in some individuals than in others, Phil Zimbardo (the psychologist who ran the Prison Experiment) offers a different explanation.  In his view, it is the system (or the apple “barrel”) that causes the behavior.   That is, the exceptional moral character necessary under such extremely difficult conditions is tantamount to heroism.

The problem with traditional ethics education is that it is predicated on the imperfect premise that individuals can, thru reason, somehow be made immune to failures of moral character.  In Zimbardo’s view, behavior in social settings results from a negotiation between individuals and the institutions in which they are embedded.  As such, it may be that context — the very thing reductionist science seeks to strip away — is the most important determining factor in human behavior after all.

Zimbardo Lucifer Effect


Note: the video below contains powerful, disturbing images and profane language.  A carefully redacted account of the experiment is available at this link.

Zimbardo calls the imposition of conditions that transform moral character the Lucifer Effect(Note: The Zimbardo “Lucifer Effect” lecture linked at left contains extraordinarily disturbing images, especially in Parts 2 and 9.  Sensitive viewers may either skip Parts 2 and 9 in YouTube or avoid these images by following the links below that segment the lecture into parts, skipping the most graphic details in Part 2, or other parts with the warnings below).

Part 1: Introduction to the Lucifer Effect.

Part 3: Who?  Or What Is Responsible for the Lucifer Effect?

Part 4: The Fundamental Attribution Error and the Power of the Social Compliance

Part 5: How to Create Evil in Good People

Part 6: De-Individuation, Demonization and the Evil of Inaction

Part 7: [warning: profane & sexual language, graphic images] Ethics of the Stanford Prison Experiment

Part 8: [some graphic images of torture] The Predictability of Abu Ghraib

Parts 9 & 10 are a detailed analysis of the Bush Administration prosecution of Abu Ghraib guards, policies regarding torture, and transformative changes to American law that allow designation of “unlawful enemy combatants” for whom Constitutional rights no longer apply.

Part 11:  The Psychology of Heroism