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.
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