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.

The Question of Intergenerational Equity

Until now, the approach we’ve used to study the interactions between different actors in Tragedy of the Commons or environmental externalities problems has been non-cooperative game theory.  The term “non-cooperative” means that there is no mechanism for enforcement of contracts within the game, so players are not incentivized by penalties or punishment to work collectively — although they may choose to work generously together for moral or religious reasons, or purely out of an enlightened self interest.  For example, in a repeated game, the players might realize that a little cooperation in the early rounds can build trust that pays off in later rounds.

In this video, Richard Dawkins explains a computer programming competition to see which strategy — cooperating or defecting or some combination thereof — would be the most successful in a repeated Prisoners Dilemma game.  Sure enough, the “nice” program Tit for Tat  was the most successful of all strategies.  In fact, nice strategies generally did better than selfish strategies, largely because they can expect to encounter other “nice” strategies willing to consider mutual cooperation.

This view of enlightened self-interest, in which spontaneous cooperation is rewarded, is most common when the parties can:

  1. communicate with each other,
  2. identify strongly with each other, especially in opposition to other groups,
  3. reciprocate with each other, and
  4. feel the consequences of failing to cooperate almost immediately.

In most situations, these conditions could be met in theory but might be difficult to realize in practice.

However,there is one problem in which it is impossible for at least three of these conditions to be met at all: climate change.

Because the effects of climate change are gradual and delayed, the individuals most responsible for the problem are unlikely to feel consequences that happen so far in the future that those most impacted have not yet been born.  Thus, there can be no communication, no reciprocity, only a remote sense of consequences, and identification is contingent upon fuzzy notions of protecting unborn great grandchildren.  In other words, the usual mechanisms for effecting collective action via enlightened self-interest are, in the special case of climate change, inaccessible.

This raises the question of what, if anything, present generations owe to the future.  If current behaviors are so damaging to the well-being of future generations that their quality of life has been severely constrained, then it can certainly be said that future people have been harmed.  Because it is reasonable to expect that future people should have the same opportunities to pursue happiness as we at present, moral sensitivity demands consideration of that harm.  This has been called the problem of Intergenerational Equity.

The Future Ain’t What it Used to Be

The traditional economic approach to problems of inter-temporal equity is to compare the value of future events to those of the present by discounting the future — i.e., counting future benefits less when comparing them to benefits available now.  Thus, the promise of $2 ten years from now might be considered worth giving up only $1 today.

There are several reasons to take this approach, including:

  1. The necessity of compensating promise holders (who accept deferred compensation) for the risk that they might never get paid at all.  To accept present sacrifices, promise holders want a larger payoff in the future.
  2. The necessity of compensating promise holders for the opportunity costs of deferring compensation when, if they had collected earlier, they might have earned interest on the money by lending it to someone else.
  3. The natural preference for people to prefer early payments rather than late.

The implication is that deferring compensation involves near-term sacrifice for long-term gain.  The result can feel like torture, but ultimately leads to success.

Nonetheless, for very long-term problems, even this approach of inter-temporal discounting fails to encompass long-term problems of sustainability, given the reality that sacrifices will be required of people who will never be able to reap the benefits.  Consequently, the question of intergenerational equity can only be understood as a moral problem, and not a problem of enlightened self-interest.  While the present generation can constrain the resources and the alternatives available in the future, the future generation has no recourse, no voice, and no ability to impact the fortunes of the present.  Given the absence of interaction between the generations, there is no way that the problem of intergenerational equity can be resolved by cooperation between generations.

In this video, Chilean economist Manfred Max-Neef argues that self-interest among political leaders works against resolution of long-term problems.  Moreover, he feels powerless to act in concert with others, even within the structure of the World Futures Council, a non-governmental organization found explicitly for the purpose of advancing the interests of future generations (whatever those might be).

Weak vs. Strong Sustainability

There are currently two arguments that attempt to resolve the question of what moral obligation the present generation might have to future generations.  The first of these is called strong sustainability and it holds that resources and management alternatives should be conserved for future generations in kind.  The second is weak sustainability, which is more optimistic about the capacity for future generations to be able to meet their own needs by discovering substitutes for depleted resources.  For example, a strong sustainability argument would prohibit whaling on the scale with which it was pursued in the mid-19th century, nearly driving whales to global extinction.  However, the weak sustainability argument says that it is natural and efficient to use the highest quality, most accessible resources first, and invest a portion of those resources in new discoveries that will provide a high quality of life when the best resources are depleted.  In an economic sense, petroleum from oil drilling provided a substitute for whale oil as a lubricant and in lamps, thereby sparing the remaining whales and enabling greater gains in the quality of life (at least for many humans).

Whereas the strong sustainability argument is easy to implement in that it requires only an understanding of present resources, rather than knowledge of  future discoveries that may or may not come to pass, the strong sustainability view requires much greater sacrifices than the weak in the present day.  The weak sustainability approach is more  tempting, but still demands an answer to the question, “What, specifically, is owed to the future?”

The answer provided by Nobel laureate economist Robert Solow is simple: knowledge.

In particular, Solow argues that the present should be making sacrifices in their level of consumption to fund research that discovers new resources or makes application of remaining resources to human needs more efficient.  In Solow’s view, it is morally satisfactory to be using up all the petroleum so long as we invest in hybrid cars or other technologies that will allow future generations to enjoy the benefits of the fuel, even if they have less fuel to go around.  Thus, the moral tension for Solow is in the difficulty of weighing the needs of the present-day poor, who might benefit from welfare programs, and the future poor, who no doubt need the resources that might have been spent on welfare to be invested in research and development instead.

One interesting aspect of Solow’s argument relates back to externalities.  Because knowledge can never be used up, like petroleum or fish, knowledge is not a rivalrous good.  One person’s use of knowledge does not necessarily keep others from using the same knowledge.  Therefore, research that generates new knowledge typically results in positive externalities, meaning that there are spill-over benefits to parties that did not invest in the research at all.  This is exactly the opposite problem of negative externalities caused by pollution, but also creates a new moral dilemma called the free rider problem, where the best possible strategy for any one individual would be to let others make the sacrifices necessary to perform basic research, but still enjoy the benefits of such research by reaping the positive externalities.  As we have seen before, in a free rider problem, what is optimal at the scale of the individual is tragic at the scale of society as a whole.

Philosophers on Climate Change


Dale Jamieson is a well-known American philosopher who writes extensively about ethics.  In this video, he explains philosophy as a process  of reasoning through decisions.

The implication is that everyday life presents us with a set of problems that are amenable to what Jamieson calls “rational engagement”.  But Jamieson admits that certain complex problems in sustainability pose special challenges to normal philosophical reasoning.

According to Jamieson, climate change is a problem that does not resemble the standard situations that spring to mind when we think of typical moral problems – i.e., problems that revolve around fairly simple scenarios that feature readily identifiable culprits who directly wrong others, often on purpose.  In “The Moral and Political Challenges of Climate Change,” he puts the point this way:

A paradigm moral problem is one in which an individual acting intentionally harms another individual; both the individuals and the harm are identifiable; and the individuals and the harm are closely related in time and space.

This last point about proximity is the result of our moral history, the fact that our values evolved from a “low population density and low technology societies, with seemingly unlimited access to land and other resources.” In some cases, we’ve figured out to adjust for the times. In today’s high-tech world, when people are victimized from afar—say, hurt by remotely detonated bomb or virus-infected e-mails—moral judgment follows the causal breadcrumbs.  The responsible parties are pegged as malicious or thoughtless people who designed and triggered the bombs and viruses.

In other cases, however, we haven’t been able to adjust.  Our mental models lag behind the times; our outdated thinking clouds our vision and we fail to perceive the moral dimensions of dilemmas staring us in the face.  In short, 21st century problems get exacerbated by antiquated sensibilities.  Jamieson argues climate change is a glaring case — an instance where we don’t conceptualize the issue as a moral problem “because it is not accompanied by the characteristics of a paradigm moral problem.” Lacking moral clarity, the “language of science, economics, and technological development” dominate the issue.

To crystallize why, Jamieson proposes a powerful analogy. He compares climate change theft.  Like all analogies, this one is imperfect (a point surely not lost on Jamieson himself).  It is hard, though, not to be sympathetic to his reasons for proposing it.  If issues related to complexity are preventing us from seeing what we need to do to be responsible citizens, a simplified image might be just what the metaphorical doctor ordered.  An analogy is not an argument, but it can be a valuable tool to help us see where conventional wisdom falls short.

Jamieson presents six different examples (paraphrased below), each with the same outcome.  But the different mechanisms by which that outcome is achieved results in different views about moral culpability.

  1. Jack steals Jill’s bicycle.
  2. Jack is one of an unacquainted group of strangers who each, acting independently, take one part of Jill’s bicycle, resulting in a complete theft of the bicycle.
  3. Jack takes one different part from a large number of different bicycles, including one from Jill’s.
  4. Jack and Jill live on different continents.  Jack purchases a used bicycle in his home country without knowledge that the bicycle was stolen from Jill in her country.
  5. Jack lives many centuries before Jill, and consumes materials that are essential to bicycle manufacturing.  As a result, it will not be possible for Jill to have a bicycle.
  6. Acting independently, Jack and a large number of unacquainted people set in motion a chain of events that causes a large number of future people who will live in another part of the world, from ever having bicycles.

The problem exemplified by the first example is obvious. Jack is 100% the bad guy. He broke the law by committing theft. There’s no confusion as to who was harmed (Jill), who did the harming (Jack), and how the harming resulted from the intentional behavior (stealing) of a bad apple.  Bad action, easy moral assessment.

The second example makes responsibility more diffuse, but not more complicated to judge.  Jack still deserves blame.  After all, if he didn’t intentionally take part in the group theft, innocent bystander Jill would have been better off. Only some of her property would be missing.  Ultimately, Jack is now partially accountable for the theft.  If, say, eight strangers pilfered equally from Jill, Jack is 1/8 responsible.  Diffusion, here, doesn’t throw off our moral sensibilities.

In the third example, Jack intentionally harms lots of people, but each one potentially only a little.  We can still easily identify the victims, and the damage done depends upon whether an essential or insignificant bicycle part was hijacked.  Let’s say Jack stole one essential part from 100 different bicycles. Perhaps he’s now left a hundred people stranded, without transportation after a long day’s work.  A little maliciousness would go a long way, but we’d still be morally equipped to assess the situation.

In the fourth and fifth examples, Jack does harm Jill, but, unlike in the theft instances, without bad intentions.  Given the gaps in space and time, we can imagine that far from being a desired result, Jill losing out on having a bicycle is an unintended consequence.  If so, is Jack really responsible?

The answer depends on several things.  For example, how much should a reasonable person in Jack’s shoes be expected to know about the broader consequences of ordering used bicycles or consuming essential biking materials?  What other options did Jack have at his disposal to meet his own needs?  Would pursing any of those options really have helped Jill if others continued to order used bicycles or consume the scarce resource?  And, why should Jack complicate his life—indeed make sacrifices—just to help an anonymous stranger who lives far away?   Whatever answers we come up with, thinking about these questions certainly strains our moral imagination.

In the sixth example, the worst consequence arises, one that makes Jill’s individual pain pale in comparison: lots and lots people never get to have bicycles.  Moreover, the moral waters, already murky in the fourth and fifth examples, become even more clouded as the diffusion of responsibility seems to put our moral sensibilities to the test.  The adverse outcome doesn’t arise from collusion.  People have not formed mobs, tribes, or communities organized around the collective desire to deprive others of bicycles.  No “us vs. them” mentality has set in.  Rather, unintended consequences scaled-up, probably to a degree of magnitude that falls way outside the scope of what individuals like Jack are thinking about when they go about doing typical actions.

Jamieson contends climate change is structurally similar to this last scenario. Therein, he argues, lies the tragedy: “we tend not to conceptualize this as a moral problem because it is not accompanied by the characteristics of a paradigm moral problem. Climate change is not a matter of a clearly identifiable individual acting intentionally so as to inflict an identifiable harm on another identifiable individual, closely related in time and space. Because we tend not to see climate change as a moral problem, it does not motivate us to act with the urgency characteristic of our responses to moral challenges.”

What should we make of this analogy?  Renowned ethicist Stephen Gardiner finds it overly simplistic and expresses his dissatisfaction in “Is No One Responsible for Global Environmental Tragedy? Climate Change as a Challenge to Our Ethical Concepts.” Here’s the gist of his retort.

  • Bicycle theft is a fairly trivial issue compared to climate change.  Emphasis should have been given to an example where a more substantive harm results from loss of resources for “relatively trivial” reasons.  (It isn’t as if Jamieson filled in information that led us to believe Jill’s life was endangered because of Jack’s actions!)
  • Because climate change involves some scientific uncertainty, “it seems better to say that our actions impose a serious risk of significant negative and perhaps catastrophic impacts, rather than simply that they cause them.”  Emphasis should have been given to an example featuring risk assessment and existential calamity.
  • While climate change will affect vulnerable people in far away countries, it will also harm vulnerable people close to home, especially poorer people. Emphasis should have been given to a more immediate and relatable example.
  • Jamieson’s reliance on two conditions of separation—“unacquainted” and “acting independently”—is too far out-of-sync with our lived social and political reality.  The choices we make are constrained by what other do and have done previously.  Emphasis should have been given to an example featuring the actions of citizens who are “tied together in deep and important ways by structural facts about their economies and lifestyles.”
  • Generic, under-described people like Jack haven’t fueled the problem of climate change. Rather, there are clearly identifiable agents who have “emitted far more” CO2 emissions than “others over time” and significantly benefited, financially and developmentally, from doing so. Emphasis should have been given to people who “appropriate more than their fair share of a global public good.”

With these concerns in mind, Gardiner proposes the following scenario as a replacement analogy:

George and his buddies like to have big firework displays over the river.  These shoot burning debris into the air, predominantly over the poorer neighborhoods on the other side.  This has already imposed, and continues increasingly to impose, a serious risk on many people in the area (and especially future generations) that their houses will catch on fire.  George and his buddies are aware of this risk, keep saying that they will cut back, buy safer fireworks, contribute funds to the fire department in the poorer neighborhoods, and so on.  But they don’t.  Instead, they keep making the displays bigger.  They like fireworks.  (They could like other things too.  But they are used to fireworks.)

Gardiner is aware that the George and company example could be seen as misaligned with problem of climate change because the adverse consequences it details occur in the present and thus don’t delay the worst harms to future generations.  But if it helps firm up the analogy, he simply asks us to imagine “the risks are predominantly imposed on future people.”

What, then, are the stakes of accepting Gardiner’s replacement?  He claims if we do, Jamieson’s concern about the inability of our standard ethical concepts to “grasp” the moral problem of climate change disappears.  In fact, Gardiner insists, if we use the new scenario as our guiding problem, we end up with a conceptual issue that is “not very difficult”: the longstanding political problem of determining how to align individual and collective responsibilities.

In the face of such a problem, the first step towards finding a solution is to embrace “delegated political responsibility,” which, in this case, means trying to “discharge the relevant responsibilities” to the relevant leaders and institutions. Should it turn out that the leaders and institutions are ill-equipped to deal with “large global and intergenerational problems”, then “the responsibility falls back on the citizens again, either to solve the problems themselves, or else, if this is not possible, to create new institutions to do the job.”  In other words, when leaders and institutions fail, citizens are responsible for creating the mechanisms needed through “civil disobedience, revolution and the like.”  We’ve done so in the past with problems like “the abolition of slavery, the civil rights movement, and the emancipation of women.”

Put in such abstract terms, Gardiner’s proposal seems compelling. Unfortunately, it doesn’t fully solve the complexity issue that, in part, motivates Jamieson’s bicycle disappearance analogy.  Even if there are well-established traditions of “civil disobedience, revolution and the like,” these are hardly programmatic endeavors with clear guidelines for how to proceed and allocate responsibilities, like leadership roles.  Instead, they are daunting collective action problems, all the more so when placed on a global stage in a context where, as Gardiner notes, the nation-state might be an antiquated unit of moral consideration.

What both of these analogies––Jamieson’s bicycles and Gardiner’s fireworks––help us see is that two prominent ethicists who think a lot about climate change still have problems getting to the heart of the matter.  Gardiner is right, in part, that the bicycle analogy simplifies away some of the key aspects of climate change.  But, Jamieson does help us see why sustainability problems can entail complexity that challenges our moral imaginations.

People don’t wake up in the morning and say, “Boy, it’s another beautiful day. I guess it’s time to go out there and contribute to the degradation of interconnected ecological and social systems that will harm people for generations to come!”  Except for the rare citizen, activist, and scholar who spend a fair amount of time thinking about climate change, people tend to see their decisions about how much CO2 to consume as a matter of personal choice, not global accountability.

The paradigmatic view of moral responsibilities we inherited from the philosophers of the Industrial Revolution enjoins the citizen or the professional from using the misdeeds of others to justify their own.  Our Mother’s classic rhetorical question: “If Johnny jumped off a cliff, would you jump off a cliff, too?” exemplifies this train of thought.  We’re expected to behave according to a consistent moral code, regardless of the actions or interactions we have with others.

But we already know that group dynamics are extraordinarily powerful influences on individual behavior.  Humans seem to be biologically programmed to be especially sensitive to the expectations or behaviors of the other people with whom they identify as belonging to a group.  Just as our own behavior is influenced by those around us, then we must know that our behavior influences others.

The difficulty of the individualistic admonitions of our parents and our teachers is that it absolves us from considering how are own actions might change the way that others around us behave.  That is, if one of us does jump off a cliff, it turns out that others are likely to jump, too.  We see an example of this in the phenomenon of copycat crimes and contagious suicide.

The realization that our behavior is part of a complex web of interactions between the individual and the group raises a new moral question that Jamieson’s examples fail to reveal:  To what extent are we responsible for the behavior of the others around us?