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I Suppose That This Is One Way To Internalize An Externality, Turbine Edition…

August 2nd, 2010 · 14 Comments
Econ 101 · Environmental Econ

Let me start with a quick recap of the whole externality deal, in bullet-point form:

  • Externalities are side effects in a market, i.e. costs and benefits that accrue to people who neither produce or consume a product. For example, pollution is an externality because I am affected by pollution from factories even when I neither produce nor consume the products that they make.
  • Externalities can be either negative (as with pollution) or positive (as would be the case if I lived upstairs from a bakery and got the smells wafting into my apartment…though I suppose that would get old quickly).
  • When externalities are present, free markets left to themselves don’t produce the socially optimal quantity of a good or service. If there are negative externalities, the free market produces more than is socially optimal because it doesn’t take into account the cost it is imposing on society by producing. If there are positive externalities, the free market produces less than is socially optimal because it doesn’t take into account the benefits it is providing to society.
  • In these situations, taxes and subsidies respectively can increase overall welfare because they move production and consumption to the socially optimal level. Taxing or subsidizing in the amount of the externality that a good creates is referred to as “internalizing” an externality, and taxes (and subsidies, I suppose) of this form are called Pigovian taxes.
  • Note that it is not necessary for the tax revenue generated to be spent on fixing the externality for this setup to work, since the taxes and subsidies are in this case merely used as a vehicle to move the needle on production and consumption. For example, Pivogian taxes to reach the socially optimal level of pollution do not require that the tax revenue be spent on pollution cleanup, but there is an implicit assumption that the tax revenue is being used for something socially beneficial rather than being flushed down the toilet.

This is usually where the textbooks stop, which means that they ignore a number of relevant subtleties and complications associated with externalities and Pigovian taxes. First off, they act as though calculating the amount of the externality is easy, whereas I am pretty sure there is a shiny new Ph.D. and academic job waiting for anyone who has a good way of figuring this out. I mean, by what dollar amount are you inconvenienced by the pollution resulting from the production of one beanie baby? Yeah, I don’t know either. But wait, it gets even more complicated, since this answer technically depends on the framing of the question- people typically give higher answers to the question “how much would you have to receive in order to tolerate one more unit of pollution?” versus “how much would you be willing to pay in order to make one unit of pollution go away?” And this doesn’t even come near the fact that differences in income and whatnot mean that different people probably give widely varying estimates of this amount.

Even if we could put a dollar amount on an externality, we still need to address a few more things before automatically jumping on the Pigou bandwagon. (Okay fine, there isn’t actually a Pigou bandwagon…but there is a Pigou Club.) When we say that Pigouvian taxes lead to the “socially optimal” level of production, we mean that this level of production is best for society in the aggregate under the assumption that a dollar to me is the same as a dollar to you is the same as a dollar to Bill Gates. (I’m not sure why he is always my scapegoat for these types of comparisons, other than that is has a lot more money that I or probably you do.) This does not mean that *everyone* is better off under a Pivogian tax, just that the winners win more than the losers lose. For example, consider a gasoline tax to internalize the pollution and congestion externalities of driving- those with their gas-guzzling SUVs are certainly worse off, since they have to pay more in taxes than they get in benefits from cleaner air and more open highways. People without cars are better off, since there is less pollution and they aren’t paying the gasoline tax. It is important to note, however, that while they may enjoy some public services that are funded by the tax revenue, they aren’t getting compensated directly for having to put up with the remaining pollution that is still in the air. (I will allow you to make your own judgment regarding whether you’d rather have $1 in cash or $1 in government services, but I think I can guess where this audience is going to come out on that.)

Wouldn’t it be nice then if we could eliminate the governmental middle man and have companies tell people “we’re sorry we @#$! up your air, here’s some cash?” It turns out that that isn’t as unreasonable as you’d think. From The New York Times:

Patricia Pilz of Caithness Energy, a big company from New York that is helping make this part of Eastern Oregon one of the fastest-growing wind power regions in the country, is making a tempting offer: sign a waiver saying you will not complain about excessive noise from the turning turbines — the whoosh, whoosh, whoosh of the future, advocates say — and she will cut you a check for $5,000.

Hm. Theoretically, this should work if $5,000 is an appropriate estimate of the per-household cost of the externality. It probably reduces the number of turbines that the company puts up (since more turbines would mean more noise and thus a higher payout required to get households to comply), and, if the households agree to the deal, their revealed preferences show that they are being compensated adequately for their inconvenience. It’s interesting to note that the article implies that some households were refusing the offer out of principle, since they didn’t like the idea of being bought. (Are you surprised by now that people don’t act like economic robots?) If I were trying to strike this sort of deal, I think I would have approached the households before the turbines went in so that they felt a little more in control of the process. Nonetheless, this is a better strategy than an attempt to correct an externality in New Jersey:

(via Perez Hilton)

I wonder if they’re guido peacocks- what’s the bird equivalent of GTL?

Tags: Econ 101 · Environmental Econ

14 responses so far ↓

  • 1 Chuck Dolci // Aug 2, 2010 at 7:06 pm

    I am not sure I agree with the utility or value of that definition of “externality”.
    ” For example, pollution is an externality because I am affected by pollution from factories even when I neither produce nor consume the products that they make.”
    Moreover, I am not sure we have a useful definition of “pollution” – but I will leave that for another day.
    Let us assume I am a fellow out on the quiet, pristine Great Plains and I come up with an idea for a new product or service, but I realize that there is no market for my idea in Iowa, but in a high population density, wealthy, vibrant environment such as New York my idea can create, for me, a small fortune. So I up and move to NYC.
    There I am confronted with awful traffic (I take the bus or bike to my factory), terrible noise pollution, crowded streets, and my factory is right next to a noisy, sausage factory that emits malodorous, (and probably harmful) vapors. I am a vegetarian.
    However, many of the sausage factory workers buy my product or service. I am able to find skilled workers in NYC and ready capital ($$$).

    Are the crowded streets and sidewalks, noise and air pollution externalities? Do I derive no benefit from the commercial activities whose by-products are so unpleasant?
    It seems to me I am an indirect, but very real beneficiary of the activity that produces the negative externalities. Otherwise I would have stayed with the pigs in Iowa.
    Some might argue that those are still “externalities”, and it is just that the positive externalities counterbalance or outweigh the negative externalities.
    I could buy into that argument, but the problem is, no one looks at the balance, all we hear about is the negative externalities and ignore the fact that we would not / could not live without the commercial activity that generates the negative externalities – and therefore seem to invite intervention in the marketplace that, more often than not, creates more problems than we had to begin with.
    Why can we not just accept that most, so-called, negative externalities are not externalities at all, just the indirect costs of consuming and enjoying the wealth of a modern industrialized society.
    Now, don’t jump down my throat claiming I am defending “pollution”. I am doing no such thing. I am merely saying that such things are part of the total costs of civilization, and that we accept that reality while we (read “producers”) seek “cheaper” goods and services ( i.e. those that carry less onerous indirect costs).

    As far as “Pigovian taxes” Ptooey. In a pig’s eye. Does anyone really believe that that is how or why taxes are calculated, imposed, and the revenues therefrom spent? Come on.

  • 2 Jeremy R. Shown // Aug 2, 2010 at 9:45 pm

    Can you come up with anything illustrating a Coasian approach from the real world? I’m still stuck on the spark arrestors.

    PS – The socially optimal level of beanie baby production is zero.

  • 3 Justin Ross // Aug 2, 2010 at 9:50 pm

    “they didn’t like the idea of being bought” = they want more than $5,000.

    At some price, they will like the idea of being bought out 😉

    FWIW, I would not put up with the Whoosh sound for $5K, because I think the damage to my home’s value would be more than that.

  • 4 econgirl // Aug 2, 2010 at 10:48 pm

    Yeah, I find it hard to disagree with the notion that everyone has a price, so it seems like these people are basically saying that their price would be lower if they weren’t upset by the idea of the transaction.

  • 5 Joao Pedro Afonso // Aug 3, 2010 at 12:13 pm

    While I’ve heard previously the word “externality”, I was never confronted with a good explanation of it. Here, I read that and more, “internalization”, “Pigovian taxes” (my first time), and others. As Econ 101 can go, you are an wonderful teacher, Jodi, and I’m happy I discovered you.

    For instance, it is the first time I can understand the “moral” justification of putting high taxes on cigarettes and alcohol. Before today, I was wondering if the high revenues the states can have from these taxes, wouldn’t make them dependent on those forms of taxation and leave them less prone to fight the bad things. That they are seen as important sources of revenue is a clear indication they are not paying or at least they are surpassing the respective externalities, which turn them immoral: the governments would be living from “immoral” money. But from what I understood, the Pigovian taxes purpose is not to pay the negative externalities produced by commodities, since these are extremely difficult to calculate, but to put their production and consume in the right point where they should have been, if all the externalities were correctly internalized. In a way, states are selling moral legitimacy to business, putting all the economic actors in the same ground while respecting their will to do what they want. This, of course, imposes the moral duty to states and governments to solve the externalities once they are correctly identified, since they are the ones which receive the Pigovian taxes. This might offend those who ask for smaller governments, but the alternative would be an anarchic economy favoring thieves and con-mans.

    But, can I dispute one opinion in your post, Jodi? I read the article about the turbines and got the idea that the payments were a preempting strike to avoid lawsuits against the excessive noise of the generators already installed. Theses lawsuits have a chance of winning because there are laws about noise that might be objectively proven violated in the running cases. So instead of internalizing an externality, they are preempting a possible bigger legal penalty. Anyway, in the “I think I would have approached the households before the turbines went” approach, this not the case since then, they will only start the turbines (I suppose) once having the contract established with the risky families. I think we can properly speak of a externalities internalization in this case because all the potential unexpected costs are covered. Now, what we have here? The turbines mounted in places where there is no listeners, are “safe” and “automatically” allowed in that aspect. No externality cost to account. But these places are finite. After them, there are places with low people density. With the noise legislation, they cannot be used, unless the population is convinced to look aside. So, enter these $5000 checks. The point I dispute is your “It probably reduces the number of turbines”. It is the other way around: it opens space to increase the number of generators. They will be build first in the places with bigger ratio wind power/(cost+people), them in the places of smaller ratio, until the marginal cost of planting an additional wind turbine will outrank the marginal benefice.

    Does this means the explained concept of externalities is wrong? Almost sure is not. May I suggest that legislation that impose prohibitions, works as an internalization of an externality, with an infinite cost assumed to it? Once the internalization is corrected to a more accessible value, the price of placing a new turbine becomes affordable, and the number of turbines increase.

  • 6 Joao Pedro Afonso // Aug 3, 2010 at 12:20 pm

    “Why can we not just accept that most, so-called, negative externalities are not externalities at all, just the indirect costs of consuming and enjoying the wealth of a modern industrialized society.”

    I think you are missing the point, Chuck. Externalities are defined exactly like that, “the indirect costs of consuming and enjoying ” some activity or product. I understand you might feel cheated or frustrated for not be able to offer cheaper products (as a “producer”), due to the imposition of externalities internalization. However, two similar products of equal satisfaction/cost ratio must not be considered equal if they have different externalities. If one has no externalities at all, and the other produces indirect cancer after ten years, they are obviously not. Without internalizing its externalities, you cannot trust the economy to produce the ideal outcome, where the first product is favored in relation to the second. The only way open to that to happen then, is by legislation which forbids or not (the atomic bomb).

    Consider this: you might have a product in the market along with a cheaper rival that, all the externalities internalized, would have be the cheaper one, even if with a bigger price. The Internalization would work to your favor, shifting the consuming preference to your product. Or you could have in your hands, research able to produce without externalities but at cost bigger than the existent products,… but not if they had their externalities internalized. Again, in the last case, you would have the upper-hand to impose your product and win the concurrence. Of course, speaking of different scenarios, you could also be the one who would loose more, attacked by better peers, in the total internalization case. Don’t expect any sympathy from me if you are in the dark side of the force: either you have a good product in the market, or you don’t.

    The problem is that, different products or activities have different externalities. If everything has the same indirect costs in relation to its value, then all the externality theory as well the Pigovian taxes would never had happened. Simple increases in the fiscal tax rates to cover the civilization costs would have be enough.

  • 7 Joshua // Aug 3, 2010 at 4:12 pm

    My only beef with Pigou’s taxes is tangential to your description of a dollar=a dollar. The MU of money is higher with the first few dollars one makes… and if that’s all you make, then your individual dollar is worth more than Mr. Gates’.

    However, a Pigovian tax’s regressive nature can be mitigated rather easily: Cut a check to each person harmed by the externality (everybody). A bit should also be used to mitigate external impacts on non-persons (e.g., habitat, watersheds, etc.), because their impacts also have negative externalities on folks, and so mitigating them will lead to a better outcome.

  • 8 Jason // Aug 4, 2010 at 1:51 am

    Most textbooks don’t stop where you claim they do. They do usually cover Coase.

  • 9 Phil Graves // Jan 4, 2011 at 7:39 pm

    You might have left out an interesting (and to non-economists abhorrent) notion: It is only when the externalities are “inadvertent” that they are externalities…if someone smokes and inadvertently damages you, that is a negative externality. But, if they deliberately blow smoke in your face, it is *not* an externality, since they receive utility from your damage–it is not at all clear in this case whether the “socially optimal” amount of smoke blowing occurs, depending on whether how much the smoker enjoys hurting you versus how much disenjoyment you get from being hurt.

  • 10 waziri, seleman // Oct 18, 2012 at 8:18 am

    thanks for providing us with clear notes, notes are very clear and understandable, may god bless on your daily work, big up.

  • 11 Yash // May 11, 2013 at 12:45 pm

    Excellent stuff! This discussion is riveting. As a freshman though it would be nice if you added some more math to your articles, because I don’t like reading so much 😛 The other day I had a strange thought about making everyone travel in a single bus everywhere and charge everyone different prices in order to internalize every externality including how noisy they are, how much they weigh lol.

  • 12 the bliss point // Dec 16, 2013 at 11:57 am

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  • 13 The EU Emission Trading Scheme: Band-Aid for a Broken Market | the bliss point // Dec 31, 2013 at 2:18 am

    […] call this ‘internalizing‘ an external cost. And it only works if the price is […]

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