Markets and Externalities

Video ?—Illustration of Free-Riders (from movie, Bridesmaids)

Reminder about markets

A previous article used the example of the POW camp for markets, where each prisoner received the same Red Cross ration parcel, and because prisoners had different food preferences, they then traded foods with each other. This market was our metaphor for all markets, and we used the example to demonstrate why markets make our lives better.

Recall that trade benefits both the buyer and the seller—otherwise the trade would not take place. For this reason, markets are a system where a person can only take things from society if they return something of equal or greater value, making markets a win-win situation for everyone. Moreover, when someone takes things from society it ensures that person will return to society more value than anyone else could.

When John gave Sam milk in exchange for chocolate, both John and Sam were made better off. John gave Sam more milk for his chocolate than anyone else; that is why Sam chose to trade with John, and not someone else.

A train passed over the Cuyahoga River on June 22, 1969. It is not uncommon for sparks to fly from the friction of train wheels on the train track, but usually the train is passing over treated wood, rocks, or water, and will not catch fire. On this day, however, it passed over a river so polluted the river caught fire!

That is the best guess of what caused the fire, but what is known is that the river was on fire, and it was horribly polluted. What is even more surprising is that this is not the first time the river caught fire. There was 1868, 1883, 1912, 1922, 1936, 1941, 1948, 1952, and now 1969. Cleveland had been known as a town where businesses could pollute. Steel mills especially apparently dumped waste right into the river with no monitoring, no accountability, no regulation at all. One government official remarked about the river in 1969, "The lower Cuyahoga has no visible signs of life, not even low forms such as leeches and sludge worms that usually thrive on wastes."

This fire in 1969 was different though, because in just thirty minutes it did considerable economic damage. The public attention the fire brought made people realize that there was little concerned citizens could do to prevent the businesses from polluting. The government needed more power to protect the environment. In response, a Republic president (Nixon) proposed creating the U.S. Environmental Protection Agency and later approved by Congress in 1970.^??

Figure 1—Ohio River Polluted So Bad It Caught On Fire

I guess we should just say we are thankful events like this are only in the past. Except they aren't. Now, more important things are catching on fire!

Figure ??—Page 135 of Colbert's America Again

Suppose you are a fans of Stephen Colbert who bought his book, America Again, and you also live near a fracking sight. On page 135 of Colbert's book is a picture of a dragon head with instruction to cut a hole in its mouth and mount the head on your sink faucet, allowing your faucet to become a SA-WEEEET dragon. What ever was he referring to? Watch the following video and find out.

Video ?—Colbert on Fracking
(A farce about conservative's view on environmental issues)

Markets can fail when negative externalities exist

Video ?—About Externalities

It was assumed that when John and Sam traded no one else was affected by their exchange, and while this is certainly true in the POW camp it is not true in all other situations.

Suppose that for some odd reason fifteen other prisoners get sick when John and Sam trade milk and chocolate, and suppose neither John nor Sam account for this when they negotiate a trade. Obviously, the trade might benefit John and Sam while harming many others, such that the prisoners as a whole are made worse off by the trade.

The POW market now might reduce the well-being of the prisoners because a negative externality is present. A negative externality exists when a third party is harmed by the transaction.

Because buyers and sellers may only negotiate on their own behalf, ignoring any externalities affecting other people, we cannot unambiguously say that market transactions make the prisoners as a whole better off.

Video ?—Example of an Externality

use example of fracking pollution and include videos.

There are two general ways of fixing this externality problem.

1. Give property rights of the groundwater to a person or society, and allow the owners of the groundwater the ability to sue Gregory when pollution occurs. Gregory now takes into account any pollution resulting from gas extraction.
2. Have government regulate Gregory, making him use only environmentally-friendly technologies. Alternatively, government can tax Gregory an amount equal to the pollution costs he causes society to pay.

(B.3.c) Markets can fail when positive externalities exist

The previous section considered a case where other prisoners get sick when John and Sam trade milk and chocolate. Now consider the case of positive externalities, where other people benefit from the trade.

Suppose that John and Sam attempt to negotiate a trade but fail. Neither can offer the other person a trade that will make them better off. Suppose, however, that the other prisoners benefit greatly from a trade. If neither John nor Sam account for positive externalities in their negotiation, they may fail to strike a trade that brings great benefit to the prisoners as a whole.

Why would John ignore the beneficial effects on other prisoners? If others benefit from the trade but they refuse to chip-in a few items to make the trade more desirable to John, why should he make the trade? Is it fair that he must pay a cost to benefit others?

   Much of that profit stems from a single historical accident: Alone among businesses, the fossil-fuel industry is allowed to dump its main waste, carbon dioxide, for free. Nobody else gets that break – if you own a restaurant, you have to pay someone to cart away your trash, since piling it in the street would breed rats. But the fossil-fuel industry is different, and for sound historical reasons: Until a quarter-century ago, almost no one knew that CO2 was dangerous. But now that we understand that carbon is heating the planet and acidifying the oceans, its price becomes the central issue.
   If you put a price on carbon, through a direct tax or other methods, it would enlist markets in the fight against global warming. Once Exxon has to pay for the damage its carbon is doing to the atmosphere, the price of its products would rise. Consumers would get a strong signal to use less fossil fuel – every time they stopped at the pump, they'd be reminded that you don't need a semimilitary vehicle to go to the grocery store. The economic playing field would now be a level one for nonpolluting energy sources. And you could do it all without bankrupting citizens – a so-called "fee-and-dividend" scheme would put a hefty tax on coal and gas and oil, then simply divide up the proceeds, sending everyone in the country a check each month for their share of the added costs of carbon. By switching to cleaner energy sources, most people would actually come out ahead.
   There's only one problem: Putting a price on carbon would reduce the profitability of the fossil-fuel industry. After all, the answer to the question "How high should the price of carbon be?" is "High enough to keep those carbon reserves that would take us past two degrees safely in the ground." The higher the price on carbon, the more of those reserves would be worthless. The fight, in the end, is about whether the industry will succeed in its fight to keep its special pollution break alive past the point of climate catastrophe, or whether, in the economists' parlance, we'll make them internalize those externalities.
—McKibben, Bill. August 2, 2012. "Global Warming's Terrifying New Math." Rolling Stone magazine.

example of vaccinations

Government can also fail

Video ?—Does Banning the Pesticide DDT Make Us Better Or Worse Off?

References

(?)  Ohio History Central. Cuyahoga River Fire.  Accessed June 25, 2012 at http://www.ohiohistorycentral.org/entry.php?rec=1642.

(?)  Wikipedia. The Environmetnal Protection Agency. Accessed June 25, 2012 at http://en.wikipedia.org/wiki/United_States_Environmental_Protection_Agency.