Positive network externalities and the value of social media

How much is social media worth? In an interesting article in The Conversation earlier this week, Peter Martin (Australian National University) discussed the value of social media networks:

Social media is a problem for economists. They don’t know how to value it...

As the Australian Senate prepares to hold an inquiry into the impact of social media, economists meeting in Adelaide at the annual conference of the Economic Society of Australia have been presented with new findings about the value of social media that point in a shocking direction. They suggest it is negative.

That’s right: the findings suggest social media is worth less to us than the zero we pay for it. That suggests we would be better off without it.

Wait, what? There's a good that we willingly use that has negative value? People may not be purely rational decision-makers, but that will take some explaining. Here's what Martin wrote about that study:

Leonardo Bursztyn of the University of Chicago presented the findings in the keynote address to the conference...

They surveyed more than 1,000 US university students, asking a series of questions about TikTok, Instagram and Google Maps (more about maps later).

The first set of questions was designed to ascertain how much they would need to be paid (or would be prepared to pay) to be off TikTok and Instagram for a month...

The answers suggest users value these platforms a lot, on average by US$59 per month for TikTok and $47 for Instagram. An overwhelming 93% of TikTok users and 86% of Instagram users would be prepared to pay something to stay on them...

Then Bursztyn and colleagues asked a second set of questions:

If two-thirds of the students on your campus sign up to deactivate, how much would you need to be paid (or be prepared to pay) to sign up too?...

Most of the TikTok users (64%) and almost half of the Instagram users (48%) were prepared to pay to be off them, so long as others were off them, resulting in average valuations across all users of minus US$28 for TikTok and minus $10 for Instagram.

Martin notes that:

The finding is a measure of the extent to which many, many users hate TikTok and Instagram, even though they feel compelled to use them.

I'm not so sure. Maybe users dislike TikTok and Instagram that much, but there is an alternative explanation, which relates to something I cover in my ECONS101 and ECONS102 classes: positive network externalities.

An externality is the uncompensated impact of the actions of one party on someone else (a bystander). A positive externality is an externality that makes the bystander better off. For example, if I plant a nice flower garden in the front of my house, it makes me feel happy, but it also makes people walking by happier as well. The flower garden creates a positive externality for the people walking by (the bystanders). The flower garden creates value for those walkers.

A network externality means that the value of belonging to a network depends (in part) on the number of other people using the network. A positive network externality is one where the larger the size of the network, the more value each network user receives from belonging to the network. Consider Facebook as an example. If you were the only user of Facebook worldwide, you've got a place to store photos, or you can post notes to yourself. So, it provides you some value, I guess. But the value of Facebook really comes about because you can interact with your friends there. The more of your friends on Facebook, the more value it creates for you. We could tell a similar story about Instagram, or TikTok.

Now, let's consider Bursztyn's results in the context of positive network externalities. When users of TikTok or Instagram were surveyed and asked how much they would have to be paid to stop using those services for a month, they had to be paid a lot. Clearly, those services do provide value to the consumers.

Next, when the users were asked how much they would have to be paid to give up TikTok or Instagram if two-thirds of the students on their campus sign up to deactivate, the value evaporated, and became negative for many users (let's call that the 'core value' that the social network provides). Why? Because if fewer of their friends are using Instagram or TikTok, then the value from the positive network externality is much lower. They are not willing to pay much if the service doesn't provide any core value (or even negative core value), because few or none of their friends are using it (and so any positive network externality isn't enough to make it worthwhile for them to use the social network).

In The Conversation article, Martin talks about "fear of missing out" as driving the results (and so do Bursztyn et al. in the research paper that Bursztyn's keynote was based on), and that may be true to some extent, but I think that frames the total value that social networks provide in a unnecessarily negative way. We have to remember that the whole purpose of social networks is networking - interacting with others. Without the interactive and community elements, a social network might as well just be a static website. Moreover, some users do receive core value from the social network, even without the positive network externalities. 

However, it is interesting that the service (excluding any positive network externalities) of Instagram and TikTok has negative core value for many (but not all) consumers. Those consumers demonstrating a negative core value wouldn't be using the social network if their friends weren't using it. This demonstrates that while particular social networks have a stranglehold on users' attention right now, that dominance is somewhat fragile. If a new service comes along that provides a higher core value, and attracts away a sufficiently large number of users, then that can cascade into a new dominant service. That is exactly what happened when Facebook took over the social network space from MySpace, Friendster, and Bebo. Or what TikTok may be doing to YouTube right now. And this creative destruction of the dominant firms is likely to be further promoted by the 'enshittification' of these products.

We could use results like Bursztyn's to argue that social networks are a bad thing, because they provide negative core value for many consumers. Or, we could recognise that overall they do provide value, because if they didn't, then consumers wouldn't use them. Just because that value comes from the fact that many other users are also using the same network, that doesn't mean that consumers don't want these products or value them. It's just that the value mostly comes from the network, not from the product. And if someone can make a better product and create a new valuable network, then consumers will move onto this next new shiny network instead.

Read more:

• How much money would you accept to give up Facebook for a month?
• What is Facebook worth to you?

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]

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

Antimicrobial resistance vs. climate change

Careful readers of yesterday's post on antimicrobial resistance might wonder whether I also prefer regulation as a solution for climate change. After all, the problems are superficially similar. Both antimicrobial resistance and climate change are listed among WHO's top ten global public health threats, and both involve negative externalities (where one person's actions make others worse off). Both problems will require concerted international action to properly address.

However, there is an important distinction between the two problems, which means that taxes or tradeable permits (such as the Emissions Trading Scheme) are likely to be effective solutions to climate change, but are less effective for antimicrobial resistance. That distinction may have gotten a little bit lost in yesterday's post.

In the case of climate change, all reductions in carbon emissions are good, in terms of reducing future climate change. So, any policy instrument that reduces carbons emissions is moving us towards the 'optimal' level of carbon emissions (which is not zero gross emissions - all of us emit carbon dioxide when we breathe, for example). The question then becomes, how do we reduce those emissions at the lowest cost to society? Taxes and tradeable permits are credible options for reducing emissions at the lowest cost, while regulation is not (a point that Eric Crampton has made many times, such as here).

Unlike carbon emissions, reducing all antibiotic use is not a good thing. Antibiotics are still needed to deal with infections. So, taxes and tradeable permits are not good instruments for reducing the problem of antimicrobial resistance, because we shouldn't want to reduce all antibiotic use, only inappropriate antibiotic use. So, as I noted in yesterday's post, antibiotic use in agriculture is an appropriate target for a tax to reduce use, but taxing all antibiotics used in medical care would likely make us all worse off.

Sometimes, regulation may actually be the best available option. But that sure doesn't mean that regulation is always the best available option.

Read more:

• Antimicrobial resistance, and health care as a negative externality

Antimicrobial resistance, and health care as a negative externality

In 2019, the World Health Organization declared antimicrobial resistance one of the top ten global public health threats facing humanity. The idea that antibiotics may soon be ineffective, making relatively minor infections life-threatening again (as they were before antibiotics became widely available after World War II) is frankly scary. This is definitely a public health issue to watch.

The Conversation has a series of articles on antimicrobial resistance, published less frequently than is probably warranted. However, they have had a couple of articles in the last week, and this article in particular caught my attention, by Allen Cheng (Monash University):

The concept of antibiotics as a valuable resource has led to the concept of “antimicrobial stewardship”, with programs to promote the responsible use of antibiotics. It’s a similar concept to environmental stewardship to prevent climate change and environmental degradation.

Antibiotics are a rare class of medication where treatment of one patient can potentially affect the outcome of other patients, through the transmission of antibiotic resistant bacteria. Therefore, like efforts to combat climate change, antibiotic stewardship relies on changing individual actions to benefit the broader community.

An externality is the uncompensated impact of the actions of one or more people on a third party (a bystander). Externalities can be positive (they make the third party better off), or they can be negative (they make the third party worse off). Usually, economists think of health care as exhibiting positive externalities. Think about a vaccination for an infectious disease. It makes the person getting vaccinated better off, because they are less likely to get sick. It also makes other people better off, because they are also less likely to get sick (because there is one more vaccinated person who cannot pass on the infectious disease).

However, what Cheng is suggesting is that, in some cases, antibiotic use may create a negative externality, because one person using antibiotics in the wrong way increases the chances that an antibiotic-resistant bacteria emerges, which would make other people sick (and potentially, unable to be easily treated). So, while some aspects of health care have positive externalities, this seems like an example where the externality is negative.

What is to be done? Cheng suggests:

There is a lot we can do to prevent antibiotic resistance. We can:

• raise awareness that many infections will get better by themselves, and don’t necessarily need antibiotics

• use the antibiotics we have more appropriately and for as short a time as possible, supported by co-ordinated clinical and public policy, and national oversight

• monitor for infections due to resistant bacterial to inform control policies

• reduce the inappropriate use of antibiotics in animals, such as growth promotion

• reduce cross-transmission of resistant organisms in hospitals and in the community

• prevent infections by other means, such as clean water, sanitation, hygiene and vaccines

• continue developing new antibiotics and alternatives to antibiotics and ensure the right incentives are in place to encourage a continuous pipeline of new drugs.

Some of these suggestions may be more effective than others. However, I want to take a step back and see what is in the economists' toolkit for dealing with negative externalities. We need to recognise, though, that unlike canonical negative externalities like air pollution, the goal here is not to reduce all antibiotic use, but only to reduce inappropriate antibiotic use.

We can start by setting aside bargaining solutions to the externality. There are simply too many parties involved (all patients prescribed an antibiotic, all doctors, and all farmers who may want to use antibiotics) for a general agreement on antibiotic use to be negotiated. That leaves public solutions, which really comes down to command-and-control policies (that is, regulation), or market-based policies (for example, taxes).

Let's start with taxes. Taxes increase the price to consumers, and decrease the effective price received by producers, and therefore create incentives for less to be produced and consumed. That would be a good solution if we were interested in reducing antibiotic use in general, but that isn't the goal here. Except in one case, which is farm use of antibiotics. Taxing antibiotic use in agriculture, would reduce the use of antibiotics, and would probably be effective. The higher costs of production (arising from the greater direct cost of raising animals, as well as the greater indirect cost as less antibiotic use slows animal growth rates) would likely be passed onto the consumers of animal products, as well as reducing farm profits.

In the health sector though, regulation is the only remaining policy alternative. The first two of Cheng's suggested solutions fit in here - raising awareness and using antibiotics more appropriately. It does appear that governments are attempting these solutions already (for example, see here for the advice provided by New Zealand's Ministry of Health, or here for the advice provided by the Australian Government). Providing advice and recommendations is about as weak as policy can get. It is unlikely to drive substantial change. For one of the top ten global public health threats, governments should be doing more to reduce the inappropriate use of antibiotics.

I'm not usually in favour of adding layers of bureaucracy, all of which come with attendant costs. However, in this case the national oversight part of Cheng's recommendations is important. This could be implemented through initially tracking antibiotic prescriptions, then a program of random audits of patient records to ensure prescriptions are warranted, and the most appropriate antibiotic (based on what was known at the time) was prescribed. The tracking component need not be too onerous, because this information is already captured. Audits would require some funding (presumably through Te Whatu Ora Health New Zealand), but as cumulatively more audits are conducted, the audits could become better targeted over time towards unusual patterns of antibiotic prescription.

Antibiotic resistance is a serious public health concern, and is a negative externality arising from inappropriate antibiotic use. This is something that can be addressed, and should be.

[Update: I wrote a brief follow-up to this post]

The evils of academic bureacracy and bullshit work

Every now and again, you read something and feel like screaming out: "Oh my God, yes!". That was my reaction to this article in The Conversation a few weeks ago, by Meg Elkins (RMIT University), Ananta Neelim, and Robert Hoffman (both University of Tasmania). They open the article with:

Are you spending more and more time at work doing paperwork and filling in forms rather than the thing you were trained and hired for? Does this busy work often seem to resist rational purpose or questioning? Does it kill your productivity, initiative, motivation and, frankly, your self-worth and sanity?

At that point, I am thinking, you should talk about academia. In fact, that was their go-to example:

Although stories of creeping bureaucracy abound in many industries, evidence – and our own experience – suggests nowhere has the problem of red tape exploded as much as it has in universities.

Staff complain the time they have for teaching and research is being eaten up by filling in forms and writing reports of questionable value. But this gripe goes beyond the inefficiency of bureaucratic excess. Some rules demotivate because they are interpreted as patronising.

I encourage you to read the entire article, especially if you are a current student and you're wondering why academic staff aren't always as fully prepared for lectures or assessments as you would like, aren't always available, or don't always spend the time to have the time to give you all the one-on-one attention that you need. It's not because they don't care. It's literally because there are so many bureaucratic roadblocks, and so much bullshit work that gets in the way (and I loved that Elkins et al. referenced David Graeber's excellent book Bullshit Jobs, or rather the article that led to the book [*]). Time and energy are limited resources, after all.

As for me, I don't find it all that demotivating, dealing with all the bullshit work, just frustrating. I would much rather spend my time on teaching and research activities, than filling in forms, attending meetings (especially meetings about meetings), and completing formative research evaluations (as practice for real research evaluations).

The problem here is one of negative externalities. The bureaucrats and academic managers who devise the systems and processes that academics must follow only face a small proportion of the total cost of their systems and processes. Those systems and processes instead impose most of the costs on academic staff (and academic administration staff). The total cost of the systems and processes (the marginal social cost) far exceeds the small costs that the bureaucrats and academic managers face themselves (the marginal private cost). And so, we end up with more complicated, onerous, and unnecessary systems and processes than would be optimal. The optimal quantity of form-filling is much less than the unrestrained quantity - notice the similarity to the negative externalities I wrote about last week.

Is it time for academics to fight back against bullshit work? Sadly, Elkins et al. don't have much to offer on that. Their main hope appears to be that academic leaders will learn from the experience of others in cutting red tape. Unfortunately, that would mean that someone would have to lead the way. I don't see too many exemplars of that in practice.

As a group, academics are not powerless. However, the staff unions seem unconcerned with the unending rise of bullshit work, at the expense of teaching and research. They are more focused on fighting continuing below-inflation increases in salaries, and increasingly precarious work conditions. The irony is that there might be more funds for paying higher salaries, and more job security, if so many of us weren't spending so much time on bullshit work.

Individually, some academics are able to negotiate around a small proportion (but definitely not all) of the red tape, perhaps by having academic administrators or junior academic staff complete some of the tasks that would otherwise fall to them. Unfortunately, that has the effect of increasing the inequality between senior staff and top researchers (who can negotiate those deals) and junior and emerging staff (who cannot, and may end up carrying some of the burden for senior staff). Those senior staff really need to stand up for the junior staff who are being burdened with bullshit work, but the individual incentives to do so are all wrong. The principle is sort of like this:

Except, senior academic staff are forgetting the part about helping others. It is time to start.

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[*] I reviewed David Graeber's book here.

Using a Pigovian tax to correct for a negative (consumption) externality

In my previous post, I demonstrated that, if left alone, a market with a negative externality produces too much of a good, and creates a deadweight loss. At the end of that post, I noted that, if we wanted to reduce the quantity that is traded in the market, we could use a tax. Such a tax is called a Pigovian tax (named after 20th Century economist Arthur Pigou), and is the focus of this post.

Consider the same market as that previous post (the market for fireplaces, or fireplace use), as shown in the diagram below. The market operates at the point 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. Consumer surplus is the area ACPM, producer surplus is the area PMCF, the welfare cost of the negative externality is the area ACHG, and total welfare (which is the sum of consumer surplus and producer surplus, minus the area of the negative externality) is equal to the area (GEF-ECH).[*]

Now consider what happens when the government imposes an excise tax on fireplaces (or fireplace use). We will assume that the per-unit cost of the tax is exactly equal to the marginal external cost (MEC), and that the tax would be paid to the government by the sellers of fireplaces (or fireplace users). We represent the tax with a new curve, S+tax, which is exactly the same distance above the supply curve as the MSB curve is below the demand curve (that's because the tax is exactly equal to MEC). The price that consumers pay increases to PC. The effective price that producers receive (after paying the tax to the government) decreases to PS. The quantity of fireplaces (or fireplace use) decreases to QS.

What happens to economic welfare? The consumer surplus is the area ABPC, and the producer surplus is the area PSEF. The government receives tax revenue equal to the area PCBEPS (this is part of total welfare, because the government can use that revenue to provide services like schools or hospitals). The area of the negative externality is the area ABEG. Total welfare with the tax is equal to GEF. [**]

In other words, the Pigovian tax not only reduces the quantity of fireplaces (or fireplace use), but leads to an increase in total welfare (in fact, it leads to total welfare being maximised and the deadweight loss being eliminated). Economists aren't often in favour of excise taxes, but this is one case where an excise tax can make society better off.

Read more:

• The welfare impacts of a negative (consumption) externality

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[*] For the explanation of these welfare areas, see my previous post.

[**] Note that this is the same total welfare as occurred at the quantity QS in my previous post. To recap, that's because the area of the negative externality ABEG cancels out some of the total welfare that was in the combined consumer and producer surpluses and government revenue (ABEF), leaving the area GEF.

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 ABEPS, 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.

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[*] 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.

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.

Network externalities and electric vehicle subsidies

The government's Clean Car Discount scheme has been in the news this week. As Stuff reported:

The Government is changing the Clean Car programme to increase fees slapped on higher emitting vehicles, changing the rebates for zero emissions imports and lowering the threshold for eligible vehicles.

The changes come as the scheme was “successfully exceeding industry and government projections”, Transport Minister Michael Wood said, after it was reviewed a year into its full implementation.

It is timely to remind ourselves of the positive and negative aspects of a subsidy. A subsidy leads to a deadweight loss (as I outlined in the footnotes to this post from 2021 when the electric vehicle (EV) subsidy scheme was introduced). That is, there is a loss of economic welfare associated with a subsidy. However, as I noted in that same footnote:

...this assumes that there are no positive externalities associated with electric vehicles, which there probably are - a person buying an EV is a person not buying a carbon-powered vehicle, and so each EV sold reduces carbon emissions (and reducing a negative externality is the equivalent of a positive externality).

It is possible that a subsidy on a good that has a positive externality (or that reduces a negative externality) could increase total welfare. However, that is not the only reason that we might favour a subsidy for EVs.

Think for a moment about the infrastructure that exists to support petrol vehicles. In most towns and cities, there are many petrol stations where cars can refuel. It is very easy and inexpensive for a petrol vehicle owner to find somewhere to refuel. Now think about the corresponding situation for electric vehicle owners. Although there are electric vehicle charging stations around (in mall carparks, for example), the infrastructure is nowhere near as available as it is for petrol vehicles. An EV owner faces a more difficult and costly (in time and effort) exercise to charge their vehicle away from home.

Clearly, the fact that there are few places to charge EVs means that there is not as much incentive for firms to provide EV charging as there is to provide petrol refueling. Most of the reason for a lack of EV charging infrastructure is simply a lack of demand. However, there is a bit of a chicken-and-egg problem here. If there are few places to charge EVs, then few consumers will buy EVs. And if few consumers buy EVs, then there is little incentive [*] for firms to provide EV charging stations. In other words, there are positive network externalities across these two goods (EVs, and EV charging stations). The more EVs there are, the more profitable it is for a firm to provide EV charging stations. The more EV charging stations there are, the more value there is for each EV driver, since they can more easily find somewhere to charge their vehicle.

Subsidising electric vehicles may help us to get out of this chicken-and-egg situation. Having more EV owners (because EVs are less expensive as a result of the subsidy) creates incentives for firms to build out the charging infrastructure necessary to support EVs. The subsidy acts as a kickstart for the process of building more EV charging stations, which then makes it easier to own an EV, which incentivises more charging stations, and so on. The process snowballs. So, quite aside from any argument associated with environmental externalities, there is an argument to be made for a subsidy.

However, what is not at all clear is whether this is the right subsidy to achieve the goal of kickstarting an EV-charging snowball. The same outcome could be achieved by subsidising the EV charging stations, rather than the EVs. Subsidising EV charging stations might even be less costly for the government, as it would mean dealing with fewer subsidy recipients (reducing the transaction costs of the subsidy). That is the approach adopted in the US, where Tesla is making its charging network available to owners of EVs from other manufacturers, in order to receive a subsidy from the US government.

The key difference between the two subsidy options is political. Subsidising consumers to buy EVs provides a handout to voters (or at least, to voters who buy EVs). Subsidising firms to build EV charging stations provides a handout to firms. Handouts to voters play out much differently in the media than handouts to firms. It should be little surprise then, that a government might prefer to subsidise EVs rather than EV charging stations, even if subsidising the charging stations would be less costly for the same outcome.

*****

[*] Note that there isn't no incentive for firms to provide EV charging stations. Firms with environmental goals, or firms that want to look like they are supporting green causes, may provide EV charging stations even if there is little demand for them.

Read more:

• Who will really gain from the electric vehicle subsidy?

Incentivising coronavirus vaccination

A couple of weeks ago, my ECONS102 class covered externalities. An externality is the uncompensated impact of the actions of one person on a bystander. Externalities can be negative (and make the bystander worse off), or positive (and make the bystander better off). One of the examples I use for a positive externality is vaccines. A person who gets vaccinated makes themselves better off (by reducing their chance of getting sick), but also makes others better off (because there is at least one fewer person who they can get sick from) - that's a positive externality.

The problem with positive externalities is that the market, left on its own, will not ensure that enough is produced or consumed. That's because the market participants don't have an incentive to take into account the benefits that their actions confer on others. That market will produce too little, compared to the quantity that maximises societal welfare. In the case of vaccines, too few people would get vaccinated.

There needs to be some mechanism to encourage more people to purchase goods with positive externalities. One way is to subsidise them (for example, see this post about subsidising education). The subsidy effectively increases the benefits of selling the good or service (if it is paid to the sellers), or reduces the cost of the good or service (if it is paid to the buyers). Either way, it increases the amount that is produced and consumed, and can ensure the quantity is increased to the socially optimal quantity.

Alternatively, the government could find some other way to incentivise more production and consumption. Right now, we're in a situation where governments want to roll out coronavirus vaccines in the face of a substantial amount of vaccine hesitancy. Some governments have started to incentivise vaccines through more than just subsidising them and making them available for free. For example, the New York Times reported last month that:

West Virginia will give $100 savings bonds to 16- to 35-year-olds who get a Covid-19 vaccine, Gov. Jim Justice said on Monday.

There are roughly 380,000 West Virginians in that age group, many of whom have already gotten at least one shot, but Mr. Justice said he hoped the money would motivate the rest to get inoculated, as “they’re not taking the vaccines as fast as we’d like them to take them.”

Some people worry that giving monetary incentives reduces intrinsic motivation. Indeed, this famous research by Uri Gneezy and Aldo Rustichini (ungated version here) showed that fining parents for picking up their children late from a childcare centre encouraged more late pickups. When the moral incentive to pick up on time is replaced by a financial incentive, it turned out to be less effective. The corollary for vaccines is that paying people to get vaccinated could encourage fewer of them to do so.

However, to counter that argument UCLA has run some experiments showing that monetary incentives are effective, as reported by the New York Times a couple of weeks ago:

In recent randomized survey experiments by the U.C.L.A. Covid-19 Health and Politics Project, two seemingly strong incentives have emerged.

Roughly a third of the unvaccinated population said a cash payment would make them more likely to get a shot...

Similarly large increases in willingness to take vaccines emerged for those who were asked about getting a vaccine if doing so meant they wouldn’t need to wear a mask or social-distance in public, compared with a group that was told it would still have to do those things.

So, perhaps we don't need to worry so much about whether the monetary incentive would be effective. And, perhaps we wouldn't have to pay it to everyone. CBS News reported yesterday:

Health officials in Ohio have reported a surge in the amount of people getting their first COVID-19 vaccination shots, a week after Ohio Governor Mike DeWine announced the $5 million "Vax-a-Million" lottery.

Just days after DeWine said the state would award five vaccinated residents $1 million each in order to raise vaccination percentages, the Ohio Department of Health reported more than 113,000 people received their first dose of the vaccine.

Based on preliminary data, the department said the recent period showed a 53% week-to-week increase (May 13 to 18) compared to the time period before the announcement, where 74,000 people received their first dose (May 6 to 11). 

"We are seeing increasing numbers in all age groups, except those 80 and older, who are highly vaccinated already," said Ohio Dept. of Health director Stephanie McCloud. "Although the rate among that group is decreasing, it is doing so at a less rapid pace, demonstrating some positive impact even in that group."

Ohio residents 18 and older who have received at least one dose of the vaccine can enter to win one of the five $1 million prizes. Ohioans between the age of 12 and 17 who have received at least one dose of the COVID-19 vaccine can enter to win one of five four-year, full-ride scholarships to any state college or university in the state. So far, approximately one million entries have been collected, according to Ohio Lottery and Ohio Department of Health.

Gamifying vaccination by attaching it to a lottery is kind of inspired. If people who are the least risk averse are those who are least likely to get vaccinated, and also those who are most likely to play the lottery, then this could be incredibly effective in increasing vaccination rates. People constantly overestimate the chance of events happening that have small probabilities (this is one of the key features of what is called prospect theory), like winning the lottery. So, government wouldn't necessarily have to ensure that the lottery amount was high enough to ensure that it captures all of the social benefits of vaccination, making this solution more cost effective than paying everyone who got vaccinated. For example, paying 100,000 people $100 each to get vaccinated costs $10 million. But, government could possibly offer five prizes of $1 million each and get the same outcome of 100,000 people getting vaccinated for half the total cost.

Overall, New Zealand's approach to vaccination is slow and steady. We're ahead of target (see the New Zealand Herald's Vaccine Tracker), but there is a fair amount of concern about whether we will achieve the overall target (e.g. see comments here or here). There seems to be plenty of demand for vaccines right now, but if things start to slow up later, perhaps we need our own vaccine lottery?

[HT: Marginal Revolution for the NY Times article on incentives; The Dangerous Economist for the article on Ohio's lottery]

Should fossils be treated like shipwrecks?

In a new article published in the journal Contemporary Economic Policy (ungated earlier version here), Paul Hallwood and Thomas Miceli (both University of Connecticut) discuss the law and economics of paleontological discovery - that is, fossil hunting. Hallwood and Miceli note that there are three groups of fossil collectors that have different incentives, in terms of the search for fossils and/or the recovery of scientific knowledge (the public value) from those fossils:

...professional paleontologists, commercial collectors who look to sell finds for a profit, and amateur collectors who do it out of interest rather than profit.

One important point is that recovering fossils leads to both public and private value:

Private good value is realized when the pecuniary value of a fossil is realized, or if it enters directly into a private collection; public good values are created when a fossil-type and the information associated with it are added to the stock of scientific knowledge in the field of paleontology.

In other words, there are positive externalities associated with recovering some (but not all) fossils. The problem with goods that have positive externalities is that, because the social benefit (what Hallwood and Miceli term the public good value) of recovery exceeds the private benefit (private value), private fossil hunters would engage in too little fossil hunting relative to the socially efficient (welfare maximising) amount of search. So, too few fossils would be discovered. On top of that, commercial collectors have little incentive to care about the scientific value of their finds, and so would not protect them in a way that preserves knowledge.

As a policy-maker, it may be tempting to try and capture the maximum public benefit by mandating that fossils must be given to museums or public academic institutions. However, that approach actually makes the problem of under-discovery worse, because then there is no chance of a private reward for recovery. On the other hand, having no restrictions on what happens to fossils after they are found would lead to more search and more fossils being found and excavated, but an inefficiently small amount of scientific knowledge being generated (because uncareful and low-cost excavation of fossils destroys much of the scientific value, which comes from their careful preservation in context). An example of this that I use in my ECONS102 class is when early palentologists paid Chinese peasants for each fragment of fossil they found. Unsurprisingly, the peasants found large fossils and then broke them up into smaller fragments, in order to earn a greater reward.

The article works through the various incentives mathematically and graphically, then looks at the current state of the law in the U.S., which could do with some improvement. Hallwood and Miceli conclude that:

Our analysis has shown that laws protecting scientific value are warranted based on the public good nature of fossil values, but this factor potentially creates an offsetting disincentive for profit-motivated collectors to engage in search, which is an essential prerequisite to recovery. Thus, if the scientific community needs to rely at least to some extent on private collectors to locate important fossils, there must be some recognition of the incentives that those searchers face. Federal legislation in fact pays little regard to this factor.

Their solution is interesting, but fairly intuitive:

...we believe there are lessons to be learned from the common law and state legislation pertaining to recovery of historic shipwrecks, which present many of the same economic issues.

As they note in one of the footnotes to the paper, in relation to the recovery of shipwrecks:

...the admiralty courts aim to balance the recovery of private (treasure) values and public (scientific archaeological) values from sunken wrecks. Neither is prioritized over the other. Second, property rights to work over sunken wrecks are granted to private companies working on federal (submerged) lands. Third, the admiralty courts promote the collection of sound archaeological knowledge from a historic shipwreck through two devices: (1) there is variation in the percentage of treasure value retained by a salvage company depending on the quality of work performed; and, (2) in cases of poor or nonexistent archeological work, applications for permits in the future can be denied.

So, it seems that, in theory at least, we possibly should treat fossils like shipwrecks, if we want both the optimal amount of search for fossils and the recovery of the optimal amount of scientific knowledge. 

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.

Environmental activists should buy coal!

My ECONS101 class is on a teaching recess at the moment. Just before the recess though, we covered supply and demand. So, it's timely for me to consider a little bit of supply and demand here. I really liked this recent Marginal Revolution post by Alex Tabarrok:

Since climate change and what to do about it are in the news it’s time to re-up an underrated idea, buy coal! Carbon taxes increase the price of carbon and induce economic and technological substitution towards lower-carbon sources of fuel in the countries that adopt them. As carbon-tax countries reduce fuel use, however, non carbon-tax countries see the price of their fuel decline. Thus, unless all countries join the tax-coalition, there is leakage. Supply-side policies are an alternative to demand supply policies. The United States, for example, could buy out and close coal mines, including giving the workers substantial retirement/reallocation bonuses, thus reducing the world supply of coal which is still the largest source of C02 emissions.

I'm going to take things in a slightly different direction though. Let's consider the actions of environmental activist groups (or activist governments, if you like), and how they impact the market for coal. [*] The standard approach has been to try to convince consumers (or shame them) to reduce their use of coal. To the extent that the approach is effective, it reduces the demand for coal. In the diagram below, the coal market is initially in equilibrium, with a price of P0, and Q0 coal is traded. When demand decreases (from D0 to D1), the price of coal falls (from P0 to P1), and the quantity of coal that is traded (and consumed) falls from Q0 to Q1. Less coal is consumed. Job done! The environmental activists can pack up and go home for a well-earned kombucha.

Not so fast. As Tabarrok notes, the lower price of coal may encourage other countries to use more coal. Perhaps they build more coal-fired power plants to take advantage of the lower-price energy. Demand for coal increases, and we end up back where we started.

An alternative, strange as it may seem, may be for the activist groups to use their funds to buy coal mines, and shut them down. Provided the groups' property rights over the mines are secure, they can be sure production will not start up again. That has the effect of decreasing supply, as shown in the diagram below. Supply decreases (from S0 to S2), which pushes the price of coal up (from P0 to P2), and decreases the quantity of coal that is traded (and consumed) from Q0 to Q2. This approach has the added benefit that it reduces the incentives for other countries to turn around and consume more coal, because coal is now more expensive than before. Of course, this approach may be more expensive than simply trying to convince consumers to consume less, but if it is more effective in the long run, then why not try it? [**]

For completeness though, what if the environmental activists did both (convincing consumers to consume less, while simultaneously buying up and closing down coal mines). Then we have the situation below, where demand has decreased (from D0 to D1) and supply has decreased (from S0 to S2). The quantity of coal traded (and consumed) falls much further (from Q0 to Q3), but the effect on price is not easy to determine. In the diagram below, the price falls (from P0 to P3). However, that is only because the decrease in demand is drawn as being larger than the decrease in supply. If the decrease in supply were larger, the price of coal would have increased. There is also an unlikely possibility that the two changes exactly offset and the price of coal stays the same. So, in this situation we can say for sure that the quantity of coal will decrease, but the change in the price of coal is ambiguous (and so is the change in incentives for other countries to use coal).

Overall though, at the least I think there is a case for activist groups to explore this possibility. As Tabarrok concludes:

A program to leave coal in the ground could easily pay for itself in lives saved and climate stabilized.

*****

[*] For simplicity, the market diagrams I've drawn in this post ignore the fact that coal generates an externality (an uncompensated impact on those who are neither the supplier nor consumer of coal). However, drawing them with the externalities would make no difference to the underlying story in terms of the change in prices or quantities, and would simply make the diagrams more complicated. Let's keep things simple!

[**] Of course, an economist would point out that the reason 'why not' could be that the added costs of this higher-cost approach outweigh the benefits. But that requires more analysis than we have space to do here, and is a job for the environmental groups (or their pet economists).

The fable of the bees for rent

Back in 2016, I wrote a post about one of the key examples many economists (including myself) use in describing the problems associated with positive externalities, being an example involving bees and apple orchards. I won't repeat all of that post here, but instead take this bit:

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.

Forget social norms though. An article in The Conversation by Manu Saunders (University of New England) earlier this year suggests that there actually is a thriving contractual market for bees as pollinators:

To optimise yields, most growers rent European honeybee hives during crop flowering season. Honeybees were first introduced to Australia from Europe in the early 1800s. Today, the beekeeping industry includes around 600,000 managed hives and is worth around A$100 million to Australia’s economy. But it’s not just about honey and beeswax products.

Managed crop pollination services have become big business in many parts of the world, including Australia. Although most beekeepers do still keep bee hives to produce honey or wax products, paid pollination services are becoming increasingly important to the industry...

Costs per hive vary depending on the crop, covering costs to the beekeeper such as how far they have to travel, the time of year (early season pollination can be more stressful for honey bees and require more feeding costs for beekeepers to maintain hive health), and the risks (e.g. chemicals) bees might face in the crop. For almond pollination, one hive can cost around $70-100 to rent. 

To recap from my earlier post, beekeepers create a positive externality for orchardists, when their bees distribute pollen incidentally in collecting it for making honey. Orchardists create a positive externality for beekeepers because their trees provide the pollen that the bees use for making honey. Left to its own devices the market produces too little of goods that have positive externalities - there would be too few bees to satisfy the needs of the orchardists, and too few trees to satisfy the needs of the beekeepers. As we discuss in my ECONS102 class, one way of solving this problem is for the two parties to negotiate a contract, specifying the number of bees, the number of trees, and some payment (in this case, from the orchardists to the beekeepers). And it appears to be working, almost exactly as described in class.

Read more:

• Uber for bees and trees

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.

The unintended consequences of China's coal ban

Internationally, pollution is a problem, but is more of a problem in some countries than others. When it comes to dealing with the problem of pollution, policy-makers have two options: (1) a command-and-control policy, where pollution is heavily restricted (and backed by enforcement mechanisms such as fines for firms that fail to comply); or (2) a market-based solution, such as an environmental (Pigovian) tax or tradeable pollution permits (see my earlier post discussing these two options).

It is well-known that China has a severe pollution problem, and it is also well-known that when China has a problem the solution is often heavy-handed. In this case, that means a command-and-control policy that restricts pollution, in this case implemented by local officials who banned the use of coal (I might add, this is a policy favoured by some in New Zealand as well, and in place in some areas and under some conditions already). The main problem with command-and-control policies is that they are very inflexible to market conditions. However, they can also come with other unintended consequences.

So, it came as little surprise to me when South China Morning Post reported this week:

Clearly [Chinese president Xi Jinping] is highly sensitive to the anger of ordinary people at China’s sky-high levels of pollution. And clearly his message struck home with party officials. After local government officials either restricted or simply banned coal use across much of Northern China, the residents of Beijing enjoyed unseasonably blue skies and fresh air through November.

But the centrally dictated clean-up came at a heavy price. Coal is not only the main source of fuel for power stations and industry, accounting for about two-thirds of China’s electricity generation, it is also burnt to heat millions of households through Northern China.

So when officials imposed their ban on coal use in line with Xi’s concern for the environment, they triggered a price surge and supply squeeze in substitute clean energy, notably natural gas. And millions of poorer households and many towns and villages unconnected to the gas supply grid were left out in the cold.

Over the past couple of months, natural gas prices have jumped by 70 per cent, hurting energy-intensive businesses, many of which were already operating on razor thin margins. Some have been forced to shut down. That’s bad enough, but even more embarrassing as far as government officials are concerned, are the tales of personal hardship that have spread across the internet and through the media, complete with stories about schoolchildren suffering frostbite because of the lack of heating in their classrooms.

The sad thing is that none of this should have been particularly surprising. When you ban the use of coal, how are households where coal is the only heating option supposed to respond? In terms of industry and electricity generation, coal and natural gas are substitutes. When you ban the use of coal, the demand for natural gas will rise, and so will its price.

You can't just legislate away the trade-offs in decisions like these. A market-based solution, such as a tax on coal, would reduce (but not eliminate) coal use, but would also create incentives for firms and households to switch to cleaner-burning fuels. However, those changes take time. If the government wants to push through change more quickly by imposing a ban, then there are clear human costs that will have to be borne. There is no overnight fix for China's pollution problems that avoids these costs, and it appears that the government has backtracked:

Now the government is using the same mechanisms of central control to reverse its policy. That should help to solve its immediate troubles. But in the longer run the underlying problem will remain in place. As long as Beijing continues to govern by diktat, attempting to manage the supply side of the economy in order to hit arbitrary and often impractical targets, it will continue to encounter similar difficulties.

Indeed. The longer term problem is best solved by creating the right incentives.

[HT: New Zealand Herald]