Dealing with the Doritos crunch externality

This story on FoodDive last month made me laugh:

While PepsiCo’s Doritos chips are popular with gamers, the loud crunch they make has long been a source of frustration.

The beverage and snacking giant estimated that 85% percent of U.S. gamers have consumed Doritos in the past three months. But at the same time, nearly a third of individuals reported that other people’s crunching distracts them from playing well and impacts their performance.

To “help gamers keep the crunch to themselves,” Doritos is debuting what it calls “Doritos Silent.” Gamers download Doritos Crunch Cancellation software and when the technology is turned on, the software detects the crunching sounds and silences it while keeping the gamer’s voice intact.

So, PepsiCo has released software that will cancel the noise from crunching Doritos that disturb other gamers. This is very overdue! [*] There is a serious side to this story though - PepsiCo has helped to reduce a negative externality problem.

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. In this case, the gamer eating Doritos imposes a cost on other gamers, who have to suffer the loud crunching noise over their headsets - it is a negative externality. Relative to the socially optimal level of Doritos eating by gamers, gamers will eat too many Doritos, since some of the costs of their Dorito-eating are passed onto other gamers.

Now, the Coase Theorem (named for the late Nobel prize-winner Ronald Coase) suggests that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (that is, without government intervention). However, notice the key phrase here is 'without cost'. When you have many gamers interacting with each other, some (many) of whom consume Doritos, then it will be quite a complex task to get all parties to agree to a solution to this externality problem. When there are many parties to an agreement, the transaction costs (specifically, coordination costs) of arrive at the agreement will be high. So, they would hardly be bargaining without cost, we therefore can't rely on the Coase Theorem.

If private parties can't solve the externality problem themselves, that usually means we must rely on a public policy solution. That is, the government would need to step in. But not in this case. Enter PepsiCo, and their Doritos-noise-cancelling software. If gamers can't hear the Dorito crunches of other gamers, then the negative externality is eliminated.

Now the question is, will they release an update to eliminate Cheetos noise, or the noise of slurping a Pepsi?

[HT: Marginal Revolution]

*****

[*] It turns out that Discord did something similar a few years ago.

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.

Crying babies and the Coase Theorem

This week in my ECONS102 class, we've been 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.

A key part of the topic is understanding the Coase Theorem (named for the late Nobel prize-winner Ronald Coase) - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (that is, without government intervention). It's an important idea because it is tempting to believe that, whenever there is an externality, it is the government's job to fix it, often through some form of regulation. But the theorem tells us that government intervention isn't always necessary.

The Coase Theorem first requires us to recognise the rights and entitlements associated with an externality. I'll illustrate with the example from this article in the New Zealand Herald last month:

A Sydney mother is "fuming" after receiving an "unbelievable" note about her parenting in her letter box.

The new mum shared a photo of the letter on Facebook, where the next door neighbours complained about her baby crying during the night.

"We would have called you but we are never sure when you are around," the note reads.

"We just wanted to let you know that unfortunately we have had a number of disturbed nights sleep recently due to the thinness of the walls between our units."

The neighbours added while they don't have kids of their own they're sure "it's not at all easy to soothe a crying baby".

"We really would appreciate anything you can do to help us get more sleep, particularly during the early hours," the note reads.

"Thank you for your consideration of this. I am sure we all look forward to more undisturbed nights' sleep."

A crying baby creates a negative externality - they impose a cost on the neighbour, who is losing sleep. How could the two parties negotiate a solution to this problem? It depends on the rights and entitlements.

Both parties have rights here. The neighbour has the right to quiet enjoyment of their home - they shouldn't have to worry about being disturbed at night. The mother has the right to have a baby at home, and babies are known to cry. So, there are competing rights. The bargaining solution will depend on which party has the overriding rights - whose rights are protected more under the law.

Let's work it through from both possible perspectives. First, let's say that the overriding rights belong to the neighbour - their right to quiet enjoyment will be protected. The default solution is that the mother has to quiet the baby in some way (or maybe they have to move somewhere else). The alternative solution is that mother and baby stay, but they agree to pay compensation to the neighbour for the neighbour's loss of sleep. The amount of compensation would have to be at least as much as whatever the neighbour values their sleep at (otherwise they wouldn't agree, and they don't have to, since under the default solution they would get quiet). However, the compensation has to be less than whatever the mother values staying in that home with their baby at (otherwise, mother and baby would be better off moving, rather than paying the compensation).

Now let's look at it the other way. Let's say that the overriding rights belong to the mother - her right to have her baby at that home will be protected. Now, the default solution is that the neighbour has to put up with the crying (or maybe they have to move somewhere else). The alternative solution is that mother and baby move away, but are paid compensation by the neighbour in order to do so. In this case, the amount of compensation would have to be at least as much as whatever the mother values living in that house with her baby at (otherwise they wouldn't agree, and they don't have to, since under the default solution the neighbour just has to put up with the crying). However, the compensation has to be less than whatever the neighbour values their lost sleep at (otherwise, they would be better off moving or putting up with the crying, 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. In this case, given that the mother is already "fuming" about the neighbour's note, that seems unlikely.

Industrial dust and bargaining over externalities

One of the most famous results in welfare economics is the Coase Theorem - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without the need for government intervention). An externality is the uncompensated impact of the actions of one party on the wellbeing of a bystander. For instance, a factory that emits air pollution creates a negative externality for people who live nearby - the reduction in air quality makes the neighbours worse off.

Ronald Coase (1991 Nobel Prize winner) argued that externality problems are jointly produced - even though one party creates the externality (e.g. the factory), the problem is also created by the neighbours - if they didn't live next to the factory, there would be no externality problem (or at least, there would be no problem for the neighbours, as they wouldn't be living next to the factory!).

One of the implications of the idea that externalities are jointly produced, and the idea that parties to the externality might be able to arrive at some agreement to deal with the externality problem, is that the same solution to the externality may arise regardless of our starting point. To see why, let's consider a specific example, from this New Zealand Herald article from earlier in the year:

For more than four years, residents and workers in De Havilland Way, Mount Maunganui have complained organic dust from a nearby industrial building was making them sick.

Business owner Colin Alexander had a severe allergic reaction that laid him up for months. Resident Skye Sloan has to take a tablet every day to keep flu-like symptoms at bay. Dozens of other complaints have been recorded.

With health officials and an air quality investigation now backing their claims, they want authorities to do something about 101 Aerodrome Rd immediately.

They argue the operations - bulk storage and handling of stock feeds including palm kernel expeller, a controversial palm oil industry byproduct - must stop until the fine, inhalable dust particles that regularly blew into the hangars can be prevented or contained. 

There is some disagreement in the article about whether industrial dust is creating health issues for nearby residents, but let's take it as a given. However, as Coase noted, the externality problem is jointly created by the bulk storage firm and the nearby residents (who, it should be noted, are living in an industrial-zoned area). But if we want to follow through on the Coase Theorem, how can this externality problem be solved without government intervention?

The solution to the externality problem depends on the distribution of entitlements - primarily the property rights, but also liability rules. There are two competing sets of property rights here. The bulk storage firm has the right to operate - it is located in an industrial zone. If the firm has to restrict its operations, that takes away some of its rights. The residents have the right to clean air. The industrial dust is taking away some of their rights.

To determine the potential bargaining solution to the externality problem, we need to start by considering which party has the overriding rights. That is, whose rights (the bulk storage firm's, or the residents') are more important to uphold? That isn't a question that economics can answer, but obviously there are two options (the bulk storage firm, or the residents). Let's consider both in turn.

If the residents have the overriding rights (their right to clean air is seen as more important to uphold than the firm's right to operate), then the default solution to the externality problem is that the firm shuts down (or it installs some type of filter to prevent the escape of industrial dust, or finds some other way not to reduce the air quality). That isn't the only solution under this set of entitlements though. The alternative solution to the externality problem is that the firm continues to operate as before, but compensates the residents for any reduction in air quality. For this alternative solution to work though, the firm would need to pay the residents more than the value of their lost air quality (however they value it), but less than the cost to the firm of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality).

If the bulk storage firm has the overriding rights (their right to operate is seen as more important to uphold than the residents' right to clean air), then the default solution to the externality problem is that the residents have to put up with the dust (or they keep their hangar homes shut up to prevent dust getting in, or they wear dust masks, or something else). Again, there is an alternative solution to the externality problem, which in this case is that the residents compensate the firm for the cost of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality). For this alternative solution to work though, the residents would need to pay the firm more than the cost to the firm of shutting down (or the cost installing a filter, or the cost of whatever other option they can find for avoiding the reduction in air quality), but less than the value of the improved air quality the residents gain (however they value it).

Notice that which set of default and alternative solutions is available depends crucially on which party has the overriding rights, which is determined by the legal environment (as I said, economics can't answer that question). Notice also that the default solution simply upholds the existing overriding rights, while the alternative solution always involves compensation from one party to the party whose overriding rights are being foregone.

Will a bargaining solution always work? No, because as noted above it depends on the relative costs and benefits. That issue aside, many economists argue that, because of the Coase Theorem, government involvement in dealing with externalities is almost never necessary. However, the Coase Theorem depends on the parties being able to bargain without cost, and that seems unlikely. In the case of industrial dust above, even if all parties sat around a big table to talk over the issues, agreement takes time and effort (and hence, transaction costs), and is made more difficult by there being many parties involved (a firm, and many residents). Many parties creates a coordination problem, since it may be difficult even to get all parties on one side of the problem (e.g. the residents) to agree. And even if the majority agree, a small minority might then try to hold out for a better deal. And even if an agreement is struck between the parties, there needs to be monitoring of the agreement to ensure the parties follow through, and some enforcement if they don't do so, both of which entail costs.

Finally, behavioural economics suggests that even if we manage to get through all of the above, arriving at a bargaining solution that suits both parties will be made more difficult because of the endowment effect. Whichever party has the overriding rights will be most unwilling to give up those rights, and will demand extra compensation (more compensation than what they would have been willing to pay to obtain the rights in the first place!) - a point that I made in this post last year.

All of this suggests that, while the Coase Theorem is good in theory, in practice it is very difficult to execute. Most of the time, if there is an externality problem, some government intervention (even if it is just covering the transaction costs and the costs of monitoring and enforcement) will be required.

Sunshine, the value of housing and compensation for externalities

In ECON110 today, we discussed hedonic demand theory (or hedonic pricing). Hedonic pricing recognises that when you buy some (or most?) goods you aren't so much buying a single item but really a bundle of characteristics, and each of those characteristics has value. The value of the whole product is the sum of the value of the characteristics that make it up. For example, when you buy a house, you are buying its characteristics (number of bedrooms, number of bathrooms, floor area, land area, location, etc.). When you buy land, you are buying land area, soil quality, slope, location and access to amenities, etc.

In a new Motu working paper, David Fleming, Arthur Grimes, Laurent Lebreton, Dave Maré, and Peter Nunns show that sunshine is one of the important characteristics that contributes to house values. The New Zealand Herald reported a couple of weeks ago:

Motu Economic and Public Policy Research Trust has released what it calls the first research carried out anywhere in the world to specifically evaluate the extra value house buyers put on extra sunshine hours.

Arthur Grimes, a senior fellow at Motu and co-author of the study, said there was a direct correlation between more sunshine and higher values and the study was precise about how much extra value is added.

"Direct sunlight exposure is a valued attribute for residential property buyers, perhaps especially in a cool-climate city such as Wellington. However, natural and man-made features may block sunlight for some houses, leading to a loss in value for those dwellings," the study said.

The effect is quite large. Quoting from the paper:

...each additional hour of direct sunlight exposure for a house per day (on average across the year) adds 2.4% to a dwelling’s market value.

The paper also has some interesting implications in terms of negative externalities. If a high-rise apartment development will block the sunlight from nearby houses, then it will reduce the value of those houses. This constitutes a negative externality imposed on the affected homeowners. Fleming et al. note that these externalities could be dealt with through compensation:

At a policy level, our estimates may be used to facilitate price-based instruments rather than regulatory restrictions to deal with overshadowing caused by new developments. For instance, consider a new multi-storey development that will block three hours of direct sunlight exposure per day (on average across the year) on two houses, each valued at $1,000,000. The resulting loss in value to the house owners is in the order of $144,000. Instead of regulating building heights or the site envelope for the new development, the developer could be required to reimburse each house owner $72,000. In return, the developer would be otherwise unrestricted (for sunlight purposes) in the nature of development. If the development cannot bear the $144,000 then the efficient outcome is that the development does not proceed. Conversely, if the development can bear that sum, then the socially optimal outcome is for the development to occur and, from an equity perspective, the neighbours are compensated for their loss of sunlight exposure.

The idea that compensation can be used to deal with externalities relies on the Coase Theorem - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In the case of a bargaining solution to an externality based on the Coase Theorem, the solution depends crucially on the distribution of entitlements (property rights and liability rules). In this case, the homeowners have existing rights to sunlight and because an apartment development would infringe on those rights, the developer would be expected to pay compensation to the affected homeowners. This will only be viable if the total amount of compensation paid to affected homeowners is not so great that it makes the development unprofitable.

The study was based on data from Wellington. Given that development in Auckland is happening faster and involves increasing density and greater numbers of taller mixed-use buildings, it would be interesting to see if the results hold there as well. As noted in the New Zealand Herald story:

"For places other than Wellington, the value of sunshine hours may be higher or lower depending on factors such as climate, topography, city size and incomes. Nevertheless, our approach can be replicated in studies for other cities to help price the value of sunlight in those settings," Grimes said. 

So the approach is transferable, even if the results are not. It's almost certainly extendable to considering the value of volcanic viewshafts in Auckland, and hopefully someone is already thinking about undertaking that work.

The economics of reclining airline seats

The problem of reclining airline seats and the related fights between passengers was a big thing in the media in 2014 (see here and here), but has been back in the media recently. The Economist's Gulliver blog had an excellent piece earlier this month entitled "Who owns the space between reclining airline seats?". It's an interesting read, and highlights several things we discuss in ECON100 and/or ECON110, including: (1) externalities and the Coase theorem; and (2) quasi-rationality and endowment effects.

If Person A (who is sitting in front of Person B) reclines their seat, they reduce the amount of space available to Person B. This is a negative externality (an adverse impact of one person's actions on the wellbeing of a bystander). There are a few things we can take away from this example. First, as Coase originally noted, externality problems are jointly produced by the person who creates the externality and the person who is affected by it. If no one was sitting in Person B's seat, then there would be no externality problem. The externality problem only exists because of both passengers' actions (Person A reclining their seat, and Person B sitting in the seat behind). [*]

Second, the polluter pays principle is not always the best solution to an externality problem. The polluter pays principle essentially says that the polluter (in this case, Person A) is always at fault any must avoid the actions that affect the other party (by not reclining their seat), or pay them compensation. If we believed the polluter pays principle is the best solution in this case, no one would be allowed to recline their seat.

In contrast, the Coase theorem suggests that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without any government or other intervention). As Gulliver notes:

According to the theories of Ronald Coase, who won the Nobel Prize in Economics in 1991, the space between airline seats is a scarce resource. Therefore it should not matter who has the initial ownership (assuming there are no barriers to a deal being made). The market will out: whoever values the space more will buy it from the other. (In this case it would normally revert to the recliner.)

What happens if we allow passengers to make these bargaining solutions? We really don't know, as no airline has ever tried it (as far as I know). However, Gulliver writes:

Would such fights be prevented if ownership of those four inches were up for auction? This was the starting point of an experiment by Christopher Buccafusco and Christopher Jon Sprigman, two law professors, which they have written up on the Evonomics website. 

Their aim was to discover whether recliners’ pleasure at being more horizontal is greater than the amount of suffering this inflicts on the person behind. One obvious way to do this is to put a monetary value on it: find out how much the flyer in front would be willing to pay for the right to recline his seat, and compare that with the amount the person behind would be prepared to shell out to stop this from happening. 

In an online survey the researchers asked people to imagine that they were about to take a six-hour flight from New York to Los Angeles. Respondents were told that the airline had created a new policy that would allow flyers to pay those seated in front of them not to recline their seats. Some were then asked how much the passenger behind would have to pay them not to recline during the flight. Others had to specify how much they would be prepared to pay to prevent the person in front of them from reclining.

I suggest reading up the Evonomics article by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law), as there is lots of interest there. Note that it is a stated preference study - we don't know for sure what people would actually do when faced with these choices, but this is what they said they would do:

Recliners wanted on average $41 to refrain from reclining, while reclinees were willing to pay only $18 on average. Only about 21 percent of the time would ownership of the 4 inches change hands...

That sounds fine, and was based on the current default set of property rights - that people have the right to recline their seat. But then things got interesting:

When we flipped the default—that is, when we made the rule that people did not have an automatic right to recline, but would have to negotiate to get it—then people’s values suddenly reversed. Now, recliners were only willing to pay about $12 to recline while reclinees were unwilling to sell their knee room for less than $39. Recliners would have ended up purchasing the right to recline only about 28 percent of the time—the same right that they valued so highly in the other condition.

So, when people had the right to recline their seat, they wanted $41 to give it up. But, if they didn't have the right, they were only willing to pay $12 for that right. If that seems odd to you, then welcome to the world of behavioural economics. The Coase theorem suggests that the initial allocation of rights should not matter, because if the person who values the right the most doesn't start out with it, they will simply purchase it from the other. But what Buccafusco and Sprigman found suggests that this simple solution might not work. What they found was an endowment effect.

Because people are loss averse, losses make us much less happy than an equivalent gain makes us happier. For example, losing $10 is more bad news than finding $10 is good news. One of the consequences of this is that we are unwilling to give up something that we already have - we require more in compensation to give it up than what we would have been willing to pay to obtain it in the first place (this is what we call an endowment effect). Note that endowment effects are working for the 'reclinees' as well - they are willing to give up their extra knee room for $39 if they had the right to keep it, but would only be willing to pay $18 to get that right if they didn't start out with it.

The endowment effect means that this problem isn't really amenable to a simple solution, because recliners already have the default rights, and are understandably unwilling to give those rights up. And any change in policy is going to incur passenger protest - because even though we may gain knee room, passengers would be giving up their right to recline, and loss aversion almost ensures that would be a painful and unwelcome trade-off for most passengers.

*****

[*] Of course, Person B probably has little choice about where they are seated. But, there are plenty of other examples of externalities where there would be no problem if the affected person was simply somewhere else. One example I've blogged about before is people who choose to live next to mushroom farms.

Uber for bees and trees

One of the key examples we use to illustrate potential bargaining solutions to externalities involves bees and apples. The original example dates all the way back to a 1952 article in The Economic Journal by W.E. Meade (ungated here), who wrote:

Suppose that in a given region there is a certain amount of apple-growing and a certain amount of bee-keeping and that the bees feed on the apple-blossom. If the apple-farmers apply 10% more labour, land and capital to apple-farming they will increase the output of apples by 10%; but they will also provide more food for the bees. On the other hand, the bee-keepers will not increase the output of honey by 10% by increasing the amount of land, labour and capital applied to bee-keeping by 10% unless at the same time the apple-farmers also increase their output and so the food of the bees by 10%.

What Meade was describing was two positive externalities. Remember that an externality is the uncompensated impact of the actions of one party on a bystander. In the first case, the apple-farmers generate a positive externality for the bee-keepers (if the apple-farmers grow more apples, they provide an additional benefit for the bee-keepers in the form of more food for the bees and consequently, greater output of honey). In the second case, the bee-keepers generate a positive externality for the apple-farmers (if the bee-keepers keep more bees, then the apple trees will produce more fruit, increasing the profits of the apple-farmers). Now the problem here is that, because the apple-farmers are only concerned about their own profits, they don't take into account the benefit their trees provide for the bee-keepers, so they will plant too few trees. And similarly, because the bee-keepers are only concerned about their own profits, they don't take into account the benefit their bees provide for the apple-farmers, so they will keep too few bees.

One potential solutions to this positive externality problem that we discuss in class is the possibility of integration (the apple-farmers start to keep their own bees, or the bee-keepers start their own apple orchards, or the two come together to form a joint venture business that produces both apples and honey - mmmm, honey-glazed apples). Another potential solution is contracting - the bee-keepers and the apple-farmers get together and agree to a contract, that specifies the number of trees that will be grown, the number of bees that will be kept, and perhaps some side-payment from one party to the other.

In 1973, Stephen Cheung wrote a follow up to the Meade paper in the Journal of Law and Economics (ungated here), where he pointed out that contracting solutions to the bees-and-trees problem were not observed in the real world, because the transaction costs of these agreements are too high (transaction costs in this case are the costs of negotiating a suitable agreement between the apple-farmer and the bee-keeper - if the costs are high, it will be more difficult for the parties to justify the expense of coming to an agreement). Instead, a social norm developed between apple-farmers and bee-keepers in terms of the number of bees per orchard, etc. Of course, a social norm is just an informal contract by another name.

But, thinking about those high transaction costs that prevent bee-keepers and apple-farmers from easily contracting brings me to this article from the New Zealand Herald about the software-based beekeeping service BeezThingz:

BeezThingz provides a match-making service to beekeepers and land owners.

We provide our beekeepers with hive management software for inspection logging and customer management. Our land owners get all the benefits of having a beehive with none of the hassle...

How it works is people express interest through our website and then I forward that on to the appropriate beekeeper who looks after their area. The beekeeper will go out and do a site inspection, walk around the property and talk through all the potential hazards with the landowner. They will then book in a delivery date, install the bees and get a regular service schedule.

Yes, it is like Uber for bees and trees, or given that they describe it as a match-making service, maybe it is like Tinder for bees and trees? In any case, the business model is all about reducing the transaction costs of negotiating a contract between land owners and bee-keepers, since there are standard contract terms (a more formal version of the solution that Cheung noted). And when transaction costs are low, the Coase Theorem says that private parties can often solve externality problems on their own (i.e. without government intervention). Meaning in this case, the right number of bees for the right number of trees, and everyone wins.

The 'efficient' allocation of refugees

Some time back I promised one of my students I would write about the refugee crisis in Europe. So here goes: If we had free movement of people, then refugees would simply move to their preferred location (which may or may not be a Western country). From an overall global welfare perspective, this should be the preferred solution (if you want an explanation why, Michael Clement argues persuasively that there are trillion dollar bills being left on the sidewalk as a result of restrictive immigration policies in Western countries).

However, there isn't free movement of people, which means that from an economic perspective one of the interesting aspects of the crisis is how 'best' to allocate refugees between countries. Thinking about European countries that are facing the brunt of the wave of refugees, the current solutions are clearly not working. Open Europe has good coverage of the problems here. In short though, the 'Dublin regulation system', whereby refugees apply in the country where they first arrive and are returned there if they move elsewhere, has failed with peripheral European countries like Greece simply shepherding migrants through to the next country in.

An alternative solution was developed in the form of a €3bn deal with Turkey, whereby migrants are returned to Turkey, only appears to cover migrants in the thousands (compared to the 1.25 million refugees who entered Europe last year). This was essentially a Coasean bargain between the European countries and Turkey. The Coase Theorem tells us that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In this case the private parties are the EU governments and the Turkish government. This bargaining solutions would work provided the payment to Turkey is more than enough to compensate for the cost of hosting the refugees, and provided the payment is less than the alternative cost (of dealing with the refugees) for the EU governments. Also, it would work provided the transaction costs (the costs of arranging the agreement) are low, the cost of monitoring and enforcing the terms of the agreement are low, and there are no free riders (EU countries that would benefit from the agreement, but refuse to contribute their share of the €3bn). In theory the Coasean solution would work, but its failure was already being discussed when it came into force, mainly because it still fails to address the allocation of refugees between countries.

Earlier, at the end of January, Dalibor Rohac wrote an interesting op-ed on the allocation issue in the New York Times. Rohac writes:

Europe’s current refugee crisis is often presented as a quantity problem: There are simply too many migrants for the European Union to absorb. But this situation is not without historical precedent. Europe has accepted large numbers of immigrants before. The issue this time is political. It has little to do with the absolute numbers of asylum seekers. The problem lies with the European Union’s dysfunctional asylum system, which encourages countries to pass refugees on like hot potatoes, and places the burden of registering and processing asylum seekers on a small number of countries on the Union’s border...

But there are ways out of this seemingly desperate situation.

For one, the quota system, proposed by the European Commission, could be made flexible. In 1997, the Yale University legal scholar Peter Schuck proposed a system of tradable refugee quotas. The European Union would still have to agree on the total number of migrants to whom it is willing to grant asylum, and on how they would be distributed among the member states. But the quota market would allow countries such as Slovakia or Hungary, whose leaders refuse to accept any refugees, to “bribe” others to carry their obligations on their behalf, putting a concrete price tag on the unwillingness of Central Europeans to help.

Essentially the allocation issue can be solved with some sort of quota. The quota system creates a set of 'obligations' for EU countries - the obligation to accept a given number of refugees each year. In ECON110 we talk about four criteria of an efficient property rights system, and effectively these obligations are a form of property rights (albeit, negative property rights) [*]. An efficient system should have obligations (or rights) that are: (1) universal; (2) exclusive; (3) transferable; and (4) enforceable.

Universality in this context means that all refugee flows would need to be covered by the obligations system, and all EU countries would be obligated to take refugees. The system would start to break down if there were additional flows of refugees that were not covered, or where countries were able to opt out of the system, for instance. Exclusivity in this context means that all of the costs of the refugee flows should be borne by the country that is accepting that group of refugees. This means that there can be no free riders. Transferability means that the obligations can be freely traded between countries. If the Netherlands wants to accept fewer than their quota of refugees, they might be able to trade the obligation to Sweden, presumably in exchange for something that Sweden wants. Finally, enforceability means that there must be some form of penalties (presumably from the EU) for countries that refuse to comply with their obligations. A system of obligations meeting these four criteria would be an efficient way of allocating refugees among European countries.

However, Rohac also notes an alternative solution:

...an explicit market in refugee quotas is not the only possible fix to the current crisis, according to two researchers at the University of Oxford, Alex Teytelboym and Will Jones. To bring the chaotic influx of refugees under control, the European Union could also create a centralized “matching system,” which would involve none of the cash payments that are often seen as repugnant.

[In the matching system] [a]pplicants would rank European Union countries by order of preference and submit that ordering to a central clearinghouse.

Some countries, such as Germany or Sweden, would likely remain oversubscribed. But because applicants would be submitting a complete ordering of European Union countries they are applying for, they could still be matched with, say, their second, or third choice, instead of being rejected outright.

The European Union member states would in turn specify how many and what refugees they are willing to accept. 

The problem with the proposed matching system is that no country would be obligated to take refugees, so the system would lack enforceability, and countries could easily opt out, leaving us back where we started. So, while matching might appeal to those who are squeamish about the transferability of obligations between countries, a quota system that obeys simple criteria would work much better in practice. This is provided an initial allocation of obligations could be agreed, and of course all participating countries would have an incentive to ensure that their initial allocation was as low as possible, if only so that they could obtain concessions from other countries after the system comes into force. The joys of politics!

[Update]: Reflecting on this overnight, I wrote this post as if the matching system and a system of tradeable obligations are somewhat mutually exclusive. Of course, they are quite complementary. Once a country knows how many refugees they are obligated to accept, there needs to be some mechanism to select which refugees they take, which is where matching could contribute. Similarly, a matching system will tell which refugees are most compatible with each country, but not how many each country should take (e.g. at what 'level' of compatibility should the cut-off for acceptance be?), which is where the system of tradeable obligations becomes helpful.

*****

[*] Please note that I am explicitly not referring to refugees as property here. I am simply linking the concept of a system of obligations to that of a system of property rights, because the efficiency of both systems relies on the same four criteria.

[HT] For the Open Europe blog, Marginal Revolution, which incidentally has been following the refugee issue over the past few months (see here).

Dealing with squealing children, NSW edition

I've written a couple of posts in the past about dealing with the problem of squealing children (see here and here). When I read this article last month, I thought it was time to write another. From the article:

A SYDNEY mum is furious after receiving a letter from her apartment building strata company threatening her with legal action unless she can stop her toddler from creating “excessive noise”...

In the letter, which Ms Mayer posted to Facebook over the weekend, the strata company says it has received reports from her neighbours of “shouting and screaming”, disturbing other residents and putting her in breach of the strata scheme by-laws.

Squealing (or shouting and screaming) children is a classic negative externality - an uncompensated impact of the actions of one party on a bystander. The poor residents of the apartment block face a cost that is imposed on them by the actions of the child (shouting and screaming create noise pollution). Since the child has no incentive to take into account the costs that they are imposing on the apartment residents, they generate too much noise compared to the socially efficient optimum.

How can the externality problem be solved? One solution is proposed by The Coase Theorem, which tells us that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention, or the intervention of the building strata company in this case).

However, a bargaining solution is unlikely to work for the apartment building, because it would require the child (or rather their mother) to enter into an arrangement with each of the other residents of the apartment (separately or all together). We know that bargaining solutions break down (or fail to arise) when there are many parties to the bargaining - either because of coordination problems, or because one or more parties may try to hold out against a solution, in order to get a better deal for themselves (what we refer to as a 'hold-out minority').

Instead, the apartment in the story uses a command-and-control policy - a rule against excessive noise, which if breached results in a penalty of $550 for the perpetrator (or in this case, their parent). This solution is based on the "polluter pays principle". Under this principle, the party that is responsible for the pollution is solely responsible for making restitution for the damage they cause.

However, the polluter pays principle is not always the best solution to problems of negative externalities. That is because there may be other ways of solving the problem that involve a lower cost (as I have argued before). Following this 'least cost principle', instead of imposing fines on parents for their noisy children (which would be an ongoing cost to the parents), perhaps the apartments could be better sound-proofed. That would only entail a one-off cost, and although that cost might be high initially, it would also reduce the problems of externalities from neighbours who enjoy loud dinner parties or other loud activities. Avoiding those other activities entails an ongoing cost that may be more costly overall.

Read more:

• Solutions to the problem of squealing children, Japan edition
• Dealing with squealing children at least cost

Mushroom farming causes a stink

Earlier in the week, Hawke's Bay Today reported on an ongoing battle between Te Mata Mushrooms and the Hawke's Bay Regional Council (on behalf of local residents):

The owner of Te Mata Mushrooms has lashed out at Hawke's Bay Regional Council, saying its prosecution over an alleged breach of resource consent conditions amounts to a bid to have the company shut down.

The Havelock North business is facing six charges and a maximum $600,000 in fines after complaints it has failed to contain odours generated by the compost it makes to grow its mushrooms in.

Under its 2012 resource consent, odours from the mushroom farm must not waft over its boundaries but the council says it has received numerous complaints...

The mushroom farm had been on its Brookvale Rd site since 1967 and in the past few years Hastings District Council had allowed more than 160 houses to be built nearby, Mr Whittaker said.

Ronald Coase argued that externalities are jointly produced. That is, it takes two parties to create an 'externality problem' - the party that generates the externality, and the party who is affected. In this case, if there were no residents living in close proximity to the mushroom farm (as was the case until relatively recently), then the odour from the compost would not be a problem.

Since there are now nearby residents who are affected, we need to consider whether government intervention is necessary. The Coase Theorem tells us that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In the case of a bargaining solution under the Coase Theorem, it depends crucially on the distribution of entitlements (property rights and liability rules).

If Te Mata Mushrooms has the right to compost on their property, then the default solution is that the residents just have to put up with the smell, or move elsewhere. The alternative solution is that the residents could pay compensation the mushroom farmer in exchange for the farmer reducing production, or altering their production method to produce less odour. The alternative solution would only be feasible if the compensation paid by the residents was individually less costly to each of them than the amount that they value the loss of enjoyment created by the odour, and the compensation was more than the lost profits of the mushroom farmer. Of course, the problem here is that getting all residents to collectively pay the farmer is difficult due to free-riding (some residents could choose not to pay, but would still receive the benefits if the farmer reduced the odours).

On the other hand, if residents have the right not to have their nostrils assailed by compost stench, then the default solution is that the mushroom farmer must reduce odours (through reduced production, or altered production method). The alternative solution is that the mushroom farmer could pay compensation to the residents for their loss of enjoyment of their property.

In this case, given that there are resource consents in place that limit Te Mata Mushroom's activities in terms of the odours it generates. So, it is clear that the residents have the over-riding rights. Even though the mushroom farm was there first, the time for the farmer to fight this battle over rights was at the time of the resource consent, not now. It is too late and they have to either comply, compensate the residents to placate them and avoid complaints, or face the consequences.

This might seem like a straightforward application of the polluter pays principle, but is also probably the least-cost solution to the externality as well. The cost to the farmer (who can presumably relocate further from residential areas if necessary) is likely to be lower (and a one-off capital or relocation cost) and concentrated in a single party, compared to an ongoing cost to many residents from the farm's activities.

Solutions to the problem of squealing children, Japan edition

Back in December last year, I wrote a post on dealing with the problems of squealing children at least cost:

Now, squealing children is a classic negative externality - an uncompensated impact of the actions of one party on a bystander. The poor residents of Stonefields face a cost that is imposed on them by the unscrupulous actions of the children. Since the children have no incentives to take into account the costs that they are imposing on the residents of Stonefields, they generate too much noise compared to the socially efficient optimum.

How best to deal with the problem of squealing children? In Japan, they use a command-and-control policy - a daytime noise limit of 55 decibels (night-time 45 decibels) in residential suburbs. That's not much louder than bird calls, i.e. a pretty extreme limit not conducive to playing children. Parents can be fined if their children exceed the noise limit, a solution to the problem that is based on the "polluter pays principle". Under this principle, the party that is responsible for the pollution is solely responsible for making restitution for the damage they cause.

However, Robin Harding reports in the Financial Times that Tokyo is considering changes to the noise regulations:

“In the past this wasn’t an issue but recently more people have been complaining to city halls, saying ‘the children are too loud, please stop them’,” says Yukie Nogami, chairwoman of Tokyo’s environment and construction subcommittee. “The law says city halls have to act.”

Ms Nogami’s committee will soon debate a proposal to carve out an exemption from the noise rules, either for children under 12 or for certain places such as parks and kindergartens.

In line with what I argued in December, the 'least cost' solution to squealing children might not be command-and-control policies like noise bans (which entail a high cost in foregone fun for the children), but sound-proofing the neighbourhood homes. Sound-proofing entails a one-off cost for each home, versus an ongoing cost of foregone fun. Of course, the cost of soundproofing every residential property (rather than just those located near playgrounds or day care centres) would likely be prohibitive.

However, once you have a command-and-control policy in place (like Japan's noise limits), it's going to be difficult to back out of. The noise limit created a new property right (the right to extreme residential quiet), and once created there is no Pareto-improving way to remove the right - that is, there is no way to remove the noise limits without making at least some people worse off. Who is going to be worse off? From the FT article:

About two-thirds of respondents to a consultation support the change but a minority is strongly against, complaining about everything from the lax upbringing of modern children to the effect on property prices.

The effect on property prices may well be real. If extreme quiet is valuable to Japanese homeowners (and prospective home buyers), then removing that property right is going to lower the value of residential homes (especially those close to playgrounds and day care centres). So at least some homeowners are right to be worried.

Moreover, the homeowners whose properties will be affected have a large incentive to protest the change in noise limits - the cost of the changes (in terms of lost property value) are likely high for each homeowner relative to the cost of protesting. Whereas the gains from the change in noise limits are spread widely among children and their parents, each of whom probably only gain a little from the changes. So expect lots of argument over this planned change, unless the homeowners can be adequately compensated. Following the compensation principle, if those who gain from the policy change (children and parents) can adequately compensate those who lose (affected homeowners), then the new policy (no, or higher noise limits) should be preferred. Since it would be difficult for children and parents collectively to compensate homeowners (free riders, anyone?), the compensation would likely have to come from taxpayers instead.

Of course, the better solution would have been not to have the extreme noise limit in the first place. As I noted in December (in relation to playgrounds in Stonefields):

The Coase Theorem tells us that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In the case of a bargaining solution under the Coase Theorem, it depends crucially on the distribution of entitlements (property rights and liability rules). Do children have the right to play and make noise? If so, then the residents would have liability to pay the children to be quiet - maybe buy them a bunch of Playstations and send them indoors to be quiet. Either that, or the children can just keep having fun in the playground and making as much noise as they like. On the other hand, do the residents have the right to peace and quiet? If so, then the children would have liability to compensate the residents for the noise of their playing. Either that, or they have to give up the playground.

Who has the rights? At the moment in Japan it's the homeowners, but I'm not convinced that was ever the least cost solution. As one respondent to the survey discussed in the FT article notes:

“To play and cry and make a big noise is a child’s right.”

Dealing with squealing children at least cost

Paul Little wrote an interesting Herald on Sunday column the week before last, about squealing children:

Spare a thought in your charity for the residents of Stonefields, an "urban village" at Mt Wellington where, among other things, the "planting of pohutukawa trees along the boulevards, mimics the original lava flows", a market includes "substantive family restaurant and other dining/takeaway options" and parks provide "for a range of passive and active recreational spaces".

The planning and design of the joint appears exemplary. Unfortunately, it didn't allow for the people.

Such as those who have been complaining because those parks' recreational spaces are just a little too active.

As resident Alan Gilder says: "The park is awesome but they haven't put a lot of thought into it - the flying fox generates a lot of squealing.

Squealing. How awful, but how true. Where there are children there will likely be squealing.

And where there are flying foxes there will almost certainly be a lot of squealing.

If there is a sound more aggravating than that of children enjoying themselves then I don't know what it is.

Now, squealing children is a classic negative externality - an uncompensated impact of the actions of one party on a bystander. The poor residents of Stonefields face a cost that is imposed on them by the unscrupulous actions of the children. Since the children have no incentives to take into account the costs that they are imposing on the residents of Stonefields, they generate too much noise compared to the socially efficient optimum.

How can the externality problem be solved? One option is government intervention, as Paul explains:

What to do? Perhaps the residents could crowdfund a shush monitor - someone in attendance with a decibel reader who could hiss "shush" at the children when the squealing reached a certain level.

A "shush monitor" is an example of a command-and-control policy. The local government puts in place a limit on the allowable amount of noise, and when that noise is exceeded the nasty noisemakers can be sanctioned - perhaps by fines, or sending them to bed without dessert. If the noise level consistently exceeds the limit, the playground could be closed. No more negative externality.

Now, this solution follows from what is called the "polluter pays principle". Under this principle, the party that is responsible for the pollution is solely responsible for making restitution for the damage they cause. Since the children are causing the noise pollution, they have to pay the cost of making things right. Even if that means closing the playground. So, the cost of reducing the externality in terms of foregone fun could be pretty high.

There is an alternative to the polluter pays principle. Instead of making the polluter pay, we could try to solve the problem of the externality at the least cost (maybe we call this the 'least cost principle'). Instead of closing the playground at the cost of lots of fun times (which would be an ongoing cost, since fun would be lost every year that the playground is not there), perhaps the government could soundproof the houses that are next to the park? That would be a one-off cost, and likely a lower cost in total than the lost fun.

Of course, maybe no government-based solution is required at all. The Coase Theorem tells us that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In the case of a bargaining solution under the Coase Theorem, it depends crucially on the distribution of entitlements (property rights and liability rules). Do children have the right to play and make noise? If so, then the residents would have liability to pay the children to be quiet - maybe buy them a bunch of Playstations and send them indoors to be quiet. Either that, or the children can just keep having fun in the playground and making as much noise as they like. On the other hand, do the residents have the right to peace and quiet? If so, then the children would have liability to compensate the residents for the noise of their playing. Either that, or they have to give up the playground.

Probably the right to peace and quiet prevails - in New Zealand homeowners have the right to quiet enjoyment of their property. So, the children will have to compensate the Stonefields residents for their excessive squealing. Or will they? The residents of Stonefields chose to live close to a park, and the cost of the negative externality will be factored into the price of the houses (if squealing children makes houses in Stonefields less desirable, then houses there will consequently be cheaper). So, you could argue that the residents of Stonefields have already been compensated for the negative externality, which has been incorporated into the price of housing (at no additional cost to the children). In which case, the residents should just suck it up or move somewhere quieter.