The welfare impacts of a negative (consumption) externality

As I noted earlier this week, an externality is the uncompensated impact of the actions of one person on the wellbeing of a third party. A positive externality makes the third party better off, while a negative externality makes the third party worse off. They are called externalities because they lie outside the original decision, i.e. some of the costs or benefits are external to the person whose action creates them.

The most common example that economists use to explain negative externalities is pollution. For example, from this New Zealand Herald article from earlier this year:

Two air pollutants are quietly contributing to thousands of premature deaths in New Zealand every year, shows a new analysis that’s prompted fresh calls for tougher regulations.

While New Zealand’s air quality is generally considered good by international standards, Stats NZ’s newly updated indicator has linked pollution from vehicles and fireplaces to around nine times more early deaths than last year’s road toll.

People running vehicles or fireplaces are creating a negative externality for other people - an increased risk of death from poor air quality. Let's focus on fireplaces and show that, left alone, the market will lead to too much use of fireplaces. Consider the market for fireplaces (or fireplace use) as shown in the diagram below. The market will operate at the quantity where supply (S) meets demand (D) - that is, the quantity traded will be QM (and the price of fireplaces, or fireplace use) will be PM.

However, the fireplace users create a negative externality for other people. Since this externality arises from the buyers of fireplaces (or fireplace users), we show this externality on the demand side of the market - we refer to it as a negative consumption externality. [*] This means that the benefits that fireplace users receive themselves from operating their fireplaces are higher than the benefits that society receives from those fireplaces - the difference is the negative benefit that is imposed on other people through air pollution. We show this on the diagram by differentiating between the marginal social benefit (MSB) and the marginal private benefit (MPB). The MPB is the benefit that fireplace users receive for themselves. The MSB is the marginal private benefit, minus the cost of the externality - the marginal external cost (MEC).

Now, society prefers the quantity of fireplaces (or fireplace use) to be the quantity where marginal social benefit (MSB) is equal to marginal social cost (MSC) - I'll explain why a little later in this post. That is the quantity QS, and one way to get to the quantity QS is if the price of fireplaces (or fireplace use) decreased to PS (because then, sellers would not be willing to sell so many fireplaces). Notice that in the diagram, relative to the quantity that society prefers (QS), the market produces too much (QM). There are too many fireplaces (or too much fireplace use).

Why does the market prefer QS (the quantity where MSB = MSC)? It's because that's the quantity that maximises economic welfare. Economic welfare is the sum of all of the net benefits arising from the market. First, the consumers receive some net benefit from participating in the market. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity, consumer surplus is the area ACPM. Second, producers receive some net benefit from participating in the market. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, producer surplus is the area PMCF. Third, the third parties are negatively affected by the market. The welfare cost of the negative externality is the area in-between marginal social cost and marginal private cost, up to the quantity of fireplaces (or fireplace use) traded (in this case, QM). That is the area ACHG, and it is subtracted from total welfare. Total welfare is the sum of consumer surplus and producer surplus (which is the area ACF), minus the area of the negative externality (ACHG), and is equal to the area (GEF-ECH). [**]

Now consider the market operating at the quantity QS (with the price PS). The consumer surplus is the area GEPS, the producer surplus is the area PSEF, and the area of the negative externality is the area ABEG. Total welfare at QS is equal to GEF. [***] Notice that this total welfare is larger when the quantity is QS than when the quantity is QM. If the market is left alone, there are too many fireplaces (or too much fireplace use), and this decreases total welfare by the area ECH. That area ECH is the deadweight loss of the externality.

Since the market produces too much, a relevant question is how could we get the market to produce less? A Pigovian tax (named after 20th Century economist Arthur Pigou) is one option, since taxes reduce the quantity of a good that is traded (for more on that, see this post). Requiring permits for fireplaces would be another way to limit the number of fireplaces to QS. Of course, determining the optimal quantity QS is difficult in practice. However, we can be sure that it isn't the quantity that is provided by the market.

*****

[*] In contrast, when producers produce pollution as a consequence of manufacturing other goods (for example), that is a negative production externality, which we would show on the supply side of the market.

[**] Notice that the area of the negative externality ACHG first cancels out all of the total welfare that was in the area ACEG, leaving the area ECH left over. That's why only GEF is left, while ECH is left subtracting from total welfare.

[***] Notice that the area of the negative externality ABEG cancels out some of the total welfare that was in the combined consumer and producer surpluses (ABEF), leaving the area GEF.

New Zealand banks' resistance to open banking and bank account number portability

Earlier this year, open banking was in the news. For instance, take this NewsHub article from March:

Amid pressure for the Government to do a deep dive into banks and their profits, there are calls to make it easier for Kiwis to switch banks.

That is on its way with open banking legislation and Newshub can reveal how the Government wants to pay for it: fees and another tax.

Remember back in the day when phones were bricks? And if you changed your mobile provider you couldn't take your number with you?

Well that changed, and when number portability came in, Tex Edwards used it to set up 2degrees. Now he wants the same thing for bank accounts.

"It would be a lot easier to change banks," he said. 

Changing banks can be an arduous process but there's a push to make that a whole lot easier.

"Elsewhere in the world you have bank account number portability and that has created more competition and its brought prices down, mortgage rates down and term deposits up," said Sam Stubbs, the managing director at Simplicity.

Bank account portability is on its way as part of open banking, which is two-ish years away.

The banks are in no hurry though.

It should be no surprise that the banks are in no hurry. Open banking increases their costs. However, one particular aspect of open banking, being bank account number portability, is probably the real issue for them. That's because a lack of portability generates profit opportunities, because of switching costs, and customer lock-in.

Switching costs are, unsurprisingly, the costs of switching from one good or service to another, or from one provider to another. Switching costs can be monetary (for example, a contract termination fee), or they can be non-monetary (for example, the time and effort required to make the switch). When bank account numbers are not portable, the switching costs of changing banks are quite high. If a customer wants to change banks, they need to set up new direct debits for all of their regular payments, change their banking details with their employer, with Inland Revenue, and with every other organisation that needs the customer's bank details. Changing all of those details is onerous for the bank customer, constituting a high switching cost.

Switching costs create customer lock-in. They make it unattractive for customers to switch to other providers, because customers would have to first face the switching cost. For banks, this customer lock-in means that bank customers tend to stay with their existing bank for longer than they otherwise might. Banks can then exploit their locked-in customers through higher prices for services (higher interest rates, or higher banking fees), or by selling them complementary products (like credit cards or insurance). Having locked-in customers is incredibly profitable for banks. If their customers weren't locked in, the banks would have to work harder to keep their existing customers, to avoid them being lured away by other banks. And that is why New Zealand banks are so resistant to open banking.

Forestry slash, externalities, and the Coase Theorem

This week my ECONS102 class is covering externalities. An externality is the uncompensated impact of the actions of one person on the wellbeing of a third party. Externalities can be negative (they make the third party worse off) or positive (they make the third party better off). We call them externalities because they lie outside the decision that created them - that is, some of the costs or benefits are external to the person whose action creates them.

An example of a negative externality from earlier this year was the damage caused by forestry slash. As Bryce Edwards summarised in the New Zealand Herald in February:

The weather events of January and February have caused a horrific toll, yet much of it was avoidable. The destruction caused by the storms was made much worse by the way forestry operations have changed the land in places on the East Coast of the North Island.

One of the biggest problems is the litter foresters leave behind when they harvest pine trees. The industry terms the branches and debris left to rot on the hillsides as “slash”, and in large storms this litter is prone to be washed down rivers, causing mayhem. The debris forms dams and diverts the flow of water, flooding towns and farms, and knocking out bridges and roads. In Cyclone Gabrielle the impact of slash was enormous...

The Herald’s Fran O’Sullivan wrote in the weekend about the logging problem, concluding “what we have observed over the past fortnight simply puts New Zealand in the Third World category”. This is because in other developed countries, the slash problem is better regulated or even banned. It’s a problem that has been known about for many years, and yet in New Zealand, the politicians have done virtually nothing about it, leaving society to pay for the damage caused by it.

The fact that the forestry companies can cause such great damage without being held accountable for the cost has astounded many. After all, citizens can be fined up to $5000 under the Litter Act 1979, and if the litter endangers anyone, the fine increases and can include imprisonment.

One way of understanding the forestry slash situation, and the options available for dealing with the negative externality, is to apply the Coase Theorem. This theorem, named after 1991 Nobel Prize winner Ronald Coase, states that if private parties can bargain without cost over the allocation of resources, then they can solve the problem of externalities on their own (that is, without government intervention).

The Coase Theorem forces us to recognise that both parties (the one causing the externality, in this case the forestry operators; and the one affected by the externality, in this case the affected property owners) have rights. In this case, the forestry operators have the right to operate their forestry business as they wish (which includes leaving slash on their land). The affected property owners have the right to the quiet enjoyment of their property, which includes the right not to face the risk of damage from forestry slash. These rights are in conflict with each other.

The solution to the externality problem under the Coase Theorem crucially depends on the allocation of entitlements - that is, which rights (those of the forestry owners or those of the affected property owners) are overriding - the overriding rights are those that receive the higher protection under the law. The solution to the externality problem will be different depending on whether the overriding rights belong to the forestry owners or the affected property owners. Let's work it through from both possible perspectives. However, remember that any agreement here would have had to have been made before the cyclone caused the damage.

First, let's say that the overriding rights belong to the affected property owners - their right to quiet enjoyment (and protection from the risk of forestry slash) will be protected. The default solution is that the forestry owners must not allow slash to affect other properties. They must dispose of it in some way, or otherwise prevent it from moving off their property. The alternative solution is that the forestry slash stays, but the forestry owners agree to compensate any affected property owners for the value of the risk that their property might be damaged by forestry slash. Notice that this is about the value of the risk of damage, as evaluated by the property owners. It will depend on the probability that forestry slash causes damage, and the cost of the damages that would be suffered if forestry slash causes damage. For simplicity, let's refer to it as the expected damage. The amount of compensation that the forestry owners would have to pay would have to be at least as much as the expected damage (otherwise the property owners wouldn't agree, and they don't have to, since under the default solution there would be no risk). However, the compensation also has to be less than whatever the forestry owners value the savings to be had from leaving forestry slash on the property rather than removing it or preventing it from moving off their property (otherwise, the forestry owners would be better off dealing with the forestry slash, rather than paying the compensation).

Now let's look at it the other way. Let's say that the overriding rights belong to the forestry owners - their right to operate their forestry business as they wish will be protected. Now, the default solution is that the affected property owners have to put up with the damage from forestry slash, or maybe they buy insurance to protect themselves. The alternative solution is that the affected property owners pay the forestry owners to dispose of the forestry slash (or prevent it from moving off their property). In this case, the amount of compensation would have to be at least as much as whatever the forestry owners value the savings to be had from leaving forestry slash on the property rather than removing it or preventing it from moving off their property (otherwise the forestry owners wouldn't agree, and they don't have to, since under the default solution the property owners just has to put up with the risk from forestry slash). However, the compensation also has to be less than the expected damage (otherwise, the property owners would be better off putting up with the risk, rather than paying the compensation).

The Coase Theorem tells us how a bargaining solution could arise when there is an externality problem. However, it requires both parties to reach an agreement, and in this case the agreement would have to have occurred before the cyclone. That didn't happen, and for very good reason. The solutions that the Coase Theorem proposes rely on the absence of costs. That means no bargaining costs (the costs that parties incur in the process of agreeing and following through on an agreement) and no monitoring and enforcement costs (the costs of ensuring that the agreement is followed through with). In this case, the bargaining costs would be prohibitively high, particularly because of coordination problems - there are so many potentially affected property owners that it would be difficult for all parties to agree on a solution.

So, with no bargaining solution in place, we were left with the default solution. The allocation of entitlements here appears to have been that forestry owners had the overriding rights, because it appears that the property owners were simply asked to put up with the damages, or await payouts from insurance or from the government. Moreover, there has been no expectation of compensation from the forestry owners. When private bargaining solutions fail to develop, then dealing with an externality problem necessarily falls to the government.

And this is what has made people angry. The negative externality was foreseeable (in fact, it wasn't even the first time this has happened). It existed even before the cyclone struck, although merely as a small risk of damage. However, the allocation of entitlements, which gave the forestry owners overriding rights, only became obvious after the cyclone struck. In other words, the allocation of entitlements didn't seem to matter, until it did. In hindsight, banning forestry slash from being left on properties would have been one potential public solution to deal with the problem.

This should make us wonder how many other similar situations exist, where innocent property owners might suddenly find themselves facing damages arising from other property owners doing currently lawful things. There are likely to be many such situations where bargaining costs are too high to allow a private solution to emerge to deal with the negative externality of expected damage. Forestry slash is easily frowned on in hindsight, but other situations may be even less clear as to the need for government intervention. However, as severe weather events become more common, these situations are likely to arise more often over time, and public solutions to the externality problem will only become more important.

The clean energy transition is about to cost more

The Financial Times reported on the market for electricity cables (such as those that connect between countries) back in July (paywalled):

Demand for interconnectors and other energy infrastructure such as wind turbines is growing rapidly, putting unprecedented strain on supply chains for electricity cable and the converter stations needed for connection to the grid. 

Supplies of both are concentrated among relatively few companies, with high barriers to entry. The potential difficulty of securing raw materials such as copper, and a lack of skilled labour needed for factories, risk putting a brake on new supplies.

Manufacturing slots are booked up, and costs are climbing. “You’re in a dogfight”, says one senior wind industry executive, describing a scramble for converter stations.

Many countries are trying to increase their renewable energy generation, as well as interconnecting electricity infrastructure between countries. All of this requires high-capacity electricity cables and associated equipment. The effect of this increasing demand on the market for electricity cables is shown in the diagram below. The market started at equilibrium, where the supply curve S0 met the demand curve D0. The equilibrium price of electricity cables was P0, and the quantity of cables traded was Q0. With demand increasing to D1, then there are two possibilities. First, if prices are kept at the original price of P0, then the quantity of cables supplied remains at Q0, but the quantity of cables demanded increases to QD. There will be a shortage of electricity cables. Alternatively, the market adjusts, and the price increases to the new equilibrium price of P1 (where the supply curve S0 meets the new demand curve D1), while the quantity of cables traded increases to Q1. Of course, the electricity cable suppliers would prefer the price to rise, since that means higher profits for them.

These dynamics apply not just to the electricity cables, but also to the other equipment and infrastructure required for the clean energy transition. So, with increasing demand for electricity cables, it seems likely that the infrastructure required for clean energy transition is going to cost more.