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.

Rent control and vacant properties in India

Across the street from my home is a vacant house. It's been vacant since at least mid-2019. In the middle of a housing crisis, the house remains vacant. Various people in the neighbourhood have wondered why the owner doesn't rent the property out. It made one of our neighbours incredibly angry. They wanted to buy a house (in 2019), but they couldn't find that was affordable. And yet, the house next to their rented home was vacant.

Why is the house vacant? Why won't the owner rent just it out? If you look at it, you realise that there are a lot of impediments to becoming a landlord. On 1 July 2019 (around about the time that the house was vacated by its owner), the government introduced new 'healthy homes' standards, that all rental properties would eventually need to meet. The house would need to be insulated, and meet heating and ventilation standards, along with some other conditions. If that would require expensive upgrading of the house (and that seems entirely plausible), then the landlord might have decided it would not be worth the hassle, and has since kept the property vacant. [*]

The healthy homes standards are not the worst policy the government could have enacted that would have led to vacant houses. Thankfully they have never followed through on early indications that they were considering rent controls. It is well known (to economists, at least) that rent controls lead to a worsening of the quality of rental housing (to the extent that rent controlled housing is literally killing people in Mumbai). But rent controls also increase the number of vacant houses.

A good examination of why vacancy rates are higher when rent controls are in place was provided by this recent article, by Sahil Gandhi (University of Manchester), Richard Green (University of Southern California), and Shaonlee Patranabis (London School of Economics), published in the Journal of Urban Economics (open access). Gandhi hypothesise that rent controls and lack of state capacity for legal enforcement of contracts both reduce the security of property rights, and that leads landlords to leave their properties vacant:

Two phenomena could create uncertainty in this allocation of rights of ownership between the landlord and the tenant. First, rent control, whose aim is to protect tenants from rent increases and evictions, alters the allocation of ownership in favor of the tenant. Second, if courts take long to resolve disputes, the ownership of the property could de-facto belong to the tenant for this duration and thus increase the risks for the landlord... The presence of either of these two conditions reduces ex-ante incentives for the landlord to engage in a rental contract. High vacancy rates are a natural consequence of reducing the benefits and raising the costs to a landlord of renting.

The problem of vacancies is particularly acute in India, where:

...the vacant stock of 11.1 million units could house almost 50 million people or around 13% of the urban Indian population.

Gandhi et al. use district-level data from the 2001 and 2011 Indian Censuses, essentially comparing the proportion of vacant properties between districts with and without rent controls. They also look at the relationship between vacant properties and state capacity for contract enforcement, measured as the number of judges per 1000 people. They have panel data for 456 districts across 24 states (for rent control) and cross-sectional data for 580 districts across 29 states (for state capacity). In their analyses, they find that:

...a pro-landlord policy move that relaxes rent revisions could potentially reduce housing vacancy by 2.8 to 3.1 percentage points and lead to a net welfare gain...

...a one to two standard deviation increase in judges per 1000 persons (urban) could reduce vacancy by 0.43 to 0.86 percentage points...

In other words, both rent controls and a lack of state capacity for contract enforcement lead landlords to leave properties vacant rather than renting them out. Gandhi et al. conclude that:

...rent control reform and judicial capacity are two areas in need of urgent attention from policymakers. The Model Tenancy Act, approved in June 2021 by the Government of India, aims to address both issues. It allows for setting rents at market rates and requires separate fast track courts to resolve disputes between tenants and landlords. If states adopt this Act then our findings suggest that vacant housing will decline.

Note that introducing rent control, and making it more difficult for landlords to evict bad tenants, would tend to shift things in the opposite direction. Both are policies that the current New Zealand government has actively considered. The consequences are clear.

[HT: Eric Crampton at Offsetting Behaviour]

*****

[*] In the last two years, things have gotten even worse for the house. A pipe burst in 2020 and flooded underneath the house. The owner didn't do anything. A large silk tree in the front yard rotted, then finally collapsed. Still no sign of the owner. The house is virtually abandoned at this point. I suspect it is not only un-rentable (given the healthy homes standards), but is probably unsaleable as well.

Read more:

• Why rent controls have worse effects over longer time horizons
• The deadweight loss of rent control
• The deadly consequences of rent control in Mumbai
• Rent control and inequality in San Francisco
• Rent control and the redistribution of wealth

Stephen Hickson on the fight against woolly words

I'm loving Stephen Hickson's work lately. In addition to writing about the stupidity of removing GST from food last week (which I posted about here), and co-authoring a piece in The Conversation with myself and others on our 'quick takes' on Budget 2022, he wrote the most hilarious post on LinkedIn yesterday:

Woolly words...

I came across this article today (not sure if you need a subscription to read it or not but the gist of it is in the first paragraph "FIRE-FIGHTING FOAM starves the flames of oxygen. A handful of overused words have the same deadening effect on people’s ability to think. These are words like “innovation”, “collaboration”, “flexibility”, “purpose” and “sustainability”. They coat consultants’ websites, blanket candidates’ CVs and spray from managers’ mouths. They are anodyne to the point of being useless. These words are ubiquitous in part because they are so hard to argue against."

https://lnkd.in/dGmNY_ub

Imagine if the government becomes aware of the damage that the excessive use of these words is causing… there's a good chance that the Government will sign up to an international accord to limit the use of Woolly Words. In an attempt to make good on that commitment they will introduce a Woolly Words Trading Scheme (WWTS). In order to get political buy-in some sectors will initially be exempt despite being the biggest users of Woolly Words, e.g. Marketing companies. Additionally the cap on Woolly Words won’t initially be binding and so everyone will agree that the WWTS is pretty weak. Eventually this will get fixed though it will take a while. But a WWTS isn’t very sexy and doesn’t look like the government is really doing anything. So they’ll start doing things that make little sense and are expensive but look a lot sexier. For example they’ll offer to subsidise at great expense the use of better words in mission statements and annual reports of some arbitrarily favoured organisations in return for them reducing their own use of Woolly Words. Or they’ll simply ban the use of Woolly Words in some sectors such as health. While this makes these organisations and sectors less woolly it doesn’t reduce the overall quantity of Woolly Words available when the WWTS is binding. It couldn't possibly happen could it?

It's not hard to see that this is a satirical take on the emissions trading scheme, including the exclusion of agriculture, and the various tinkering the government undertakes to try and solve problems that would more easily be solved if the scheme were comprehensive. In my ECONS102 class, we characterise an efficient property rights system as one that has four key features:

1. Universal - all resources are privately, publicly, or communally owned and all entitlements are completely specified;
2. Exclusive - all benefits and costs accrued as a result of owning and using the resources should accrue to the owner whether directly or indirectly;
3. Transferable - all property rights should be transferable from one owner to another in a voluntary exchange; and
4. Enforceable - property rights should be secure from involuntary seizure or encroachment by others.

The emissions trading scheme (and the woolly words trading scheme) creates a property right - the right to emit carbon (or the right to use woolly words). The scheme will only be efficient if it is universal - that is, all emissions (or woolly words) must be covered by the scheme. When agriculture (or marketing) is excluded, they can generate as many emissions (or woolly words) as they like, essentially without consequence. If the government is concerned about their emissions (or woolly words), then the government has to create all sort of other regulations to keep them in line. Which is completely unnecessary, since including them within the trading scheme would be much more efficient (lower cost, and simpler all around).

If we really are concerned about carbon emissions (or woolly words), we have the means to limit them. Excluding favoured sectors from the trading scheme is pure politics, combined with a fair amount of fingers-in-the-ears-I'm-not-listening-to-you, and that is going to cost us far more in the long term.

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.

Land seizures, security of property rights, and efficiency in Ihumātao

In my ECONS102 class this week, we'll be talking about property rights. One of the key points in that part of the topic is discussing the characteristics of efficient (that is, economic welfare maximising) property rights. For property rights to be efficient, they need to have four characteristics. They need to be:

1. Universal - all resources are privately, publicly, or communally owned and all entitlements are completely specified;
2. Exclusive - all benefits and costs accrued as a result of owning and using the resources should accrue to the owner whether directly or indirectly;
3. Transferable - all property rights should be transferable from one owner to another in a voluntary exchange; and
4. Enforceable - property rights should be secure from involuntary seizure or encroachment by others.

For the weekly assignment in that class, I was going to assign a question about the current standoff in Ihumātao, which has been widely covered in the media over the last several months and has come to a head in the last couple of weeks (see this New Zealand Herald story as one example). My initial thought was that I could ask a simple question about how land occupation by protestors affects the efficiency of property rights. The straightforward answer is that land occupation reduces enforceability, and therefore property rights become less efficient and therefore less valuable - if your property rights are being encroached upon (and are therefore both less secure and less exclusive), then you would be less willing to have those rights. In a sense, this provides a simple explanation for why Fletcher Building may have become willing to sell the land at Ihumātao.

However, as with many things, the issue isn't quite that simple. As I was thinking about this potential assignment question, I began to consider the original land seizure by the Crown in 1863. If I asked about how efficient property rights are, some students might consider that the original land seizures as reducing the efficiency of property rights. And they would have a valid point. Obviously, if the Crown is seizing land, then that makes the property rights a whole lot less efficient. So, land occupations that result in the return of the property to its original owners could increase the efficiency of property rights, if you took a longer run perspective. At that point, I decided the assignment question was a whole lot more difficult that I had anticipated. But also, the question had become a whole lot more interesting.

What happens if land seizures are only being executed against one population group, and not others? Then the group subject to land seizures would have less efficient property rights than other groups. Consequently, the group with inefficient property rights would be willing to pay less to hold onto land (including any land that hadn't been seized!), or willing to accept less to sell their land, compared to groups with more efficient property rights. This disparity has important implications.

In the absence of market failures, economists accept that markets maximise economic welfare. Nobel Prize winner Friedrich Hayek argued that markets are efficient because goods are transferred to those who value them the most. In the case of land, we would expect land to be transferred to those who valued it the most, being those who could make the best use of the land (whether that be for farming, forestry, housing, infrastructure, or cultural values). If land seizures directed against one group (but not others) makes the targeted group willing to pay less for land, then the market would eventually transfer land away from that group, and to groups that are willing to pay more for it. However, the difference in willingness-to-pay is being driven (in part, if not entirely) by the difference in the security (and efficiency) of property rights for the targeted group. The transfer of land is not towards those who value it more, except as a result of the land seizures.

For many years, I've been wondering if there was an economic argument for redress for Crown land seizures from Māori, aside from the ethical and moral arguments that are already pretty clear. I haven't thought through all the implications here, but I think that the efficiency of property rights probably provides a basis for making such an argument.

Killing crocodiles might save crocodiles, but only with closed access

I've written a few times about endangered species, and about how assigning private property rights (such as through farming) might be one way to save them (for example, see this 2015 post about lions). This article in The Conversation yesterday, by Daniel Natusch (Macquarie University), Grahame Webb (Charles Darwin University), and Rick Shine (University of Sydney), makes a similar point:

Banning the use of animal skins in the fashion industry sounds straightforward and may seem commendable – wild reptiles will be left in peace, instead of being killed for the luxury leather trade.

But decades of research show that by walking away from the commercial trade in reptile skins, Selfridges may well achieve the opposite to what it intends. Curtailing commercial trade will be a disaster for some wild populations of reptiles.

How can that be true? Surely commercial harvesting is a threat to the tropical reptiles that are collected and killed for their skins?

Actually, no. You have to look past the fate of the individual animal and consider the future of the species. Commercial harvesting gives local people – often very poor people – a direct financial incentive to conserve reptile populations and the habitats upon which they depend.

As Natusch et al. note, if people can earn income from harvesting and selling crocodiles (or crocodile eggs), then there is an incentive to keep crocodiles around. The most straightforward example of this is farming. People are allocated private property rights over crocodiles (they own them in the general sense), and that creates an incentive for each farmer to sustainably manage their crocodiles.

However, in their article Natusch et al. are essentially arguing that the incentives are the same if you are thinking about maintaining wild populations of crocodiles. That is, if people can harvest from the population of wild crocodiles, then there is an incentive for people to maintain the population. However, while the authors appeal to previous research that supports their argument, they ignore an equally large literature on the Tragedy of the Commons. A population of wild crocodiles is a common resource - it is rival and non-excludable. Rival goods are those where one person's use of the good reduces the amount available to everyone else, i.e. in this case killing one crocodile reduces the number of crocodiles available to everyone. Non-excludable goods are those where you cannot easily prevent a person from obtaining the benefit from them, i.e. in this case it would be difficult to stop people from killing crocodiles.

The Tragedy of the Commons arises because the private incentive (to harvest as many crocodiles as you can, in order to maximise the income for your family) is not aligned with the social incentive (to keep the population sustainable). It leads to over-harvesting, and threatens the crocodile population.

Farming solves this problem by assigning property rights - it makes crocodiles a private good - rival but excludable (because only the crocodile farmers can kill them). However, what Natusch et al. are suggesting would not work without some other controls in place.

As the Nobel Prize winner Elinor Ostrom noted, the problem with common resources arises when they are open access - when everyone can access them freely with no restrictions. Private property rights are one way to restrict access, but not the only way. Another way to manage a population of wild crocodiles would be to issue harvest permits, with only permit holders allowed to kill crocodiles. This would make crocodiles closed access, and is similar to how we manage fisheries with the Transferable Quota system. This essentially creates a property right - the right to kill crocodiles.

Provided only a few permits are issued, the permit holders would have an incentive not to take too many crocodiles, because that would limit their future livelihoods. The more permit holders there are, the more the solution starts to dissolve into the open access Tragedy of the Commons, so limiting their numbers is necessary for sustainability.

So, as Natusch et al. argue, prohibiting the killing of crocodiles is not a good way to save them. However, incentives alone are not the solution. Some form of property rights needs to be created to ensure the long-term sustainability of the crocodile population.

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.

Who would want to be a landowner in South Africa right now?

From news.com.au last week:

South Africa’s ruling party says it will push ahead with plans to amend the country’s constitution to allow for the expropriation of land without compensation.

President Cyril Ramaphosa announced the decision on Tuesday following a two-day meeting of the African National Congress, which had earlier signalled its intention to redistribute land under the current laws.

The South African parliament in February voted in favour of a motion, brought by the radical Marxist Economic Freedom Fighters and supported by the ANC, to send the matter to parliament’s Constitutional Review Committee.

“It has become patently clear that our people want the constitution to be more explicit about expropriation of land without compensation, as demonstrated in public hearings,” Mr Ramaphosa said in a video message addressing “fellow South Africans, comrades, friends”.

“The ANC [has] reaffirmed its position that a comprehensive land reform program that enables equitable access to land will unlock economic growth by bringing more land in South Africa to full use and enable the productive participation of millions more South Africans in the economy.”

From the perspective of my ECONS102 class, this is great timing given that we are about to do a topic that includes property rights this coming week. Efficient (welfare-maximising) property rights have four features:

1. Universality – all resources are privately, publicly, or communally owned and all entitlements are completely specified;
2. Exclusivity – all benefits and costs accrued as a result of owning and using the resources should accrue to the owner whether directly or indirectly;
3. Transferability – all property rights should be transferable from one owner to another in a voluntary exchange; and
4. Enforceability – property rights should be secure from involuntary seizure or encroachment by others.

Obviously, if the government is about to legislate for expropriation of land without compensation, then the 'enforceability' feature is going to be absent. What does this do to the value of land? The article tells us:

Speaking to the ABC’s Foreign Correspondent on Tuesday night, cattle farmer Jo-an Engelbrecht — whose elderly parents were tortured and killed in their home on Mother’s Day — said even if he wanted to sell his farm and leave, it was now “worth zero”.

“We had several auctions in the last two or three weeks cancelled because there was no people interested in buying the land,” he said. “Why would you buy a farm to know the government’s going to take it?”

To see why land values might fall to zero, consider the land market in the diagram below (note that it is a rental market for land, as I discussed last week). Before land expropriation was likely, demand is D0 and the land rent is R0. When land expropriation becomes likely, fewer people want to have land, either because they worry that they land they have paid for will be expropriated, or because they think "why pay for land, when I can just wait and some might be redistributed to me?" Either way, the demand for land falls to D1. Notice that there is no equilibrium in this land market now, because demand and supply never meet (or if there was an equilibrium, the equilibrium price would be negative!).

To see why the lack of enforceability reduces economic welfare in the land market (i.e. why this market is inefficient), consider the areas of consumer and producer surplus. Before land expropriation was likely, the consumer (tenant) surplus is the area ABR0, producer (landlord) surplus is the area R0BCO, and total welfare is ABCO. When land expropriation becomes likely, all of these areas (consumer and producer surplus, and total welfare) fall to zero, because there is no land trading at all! Of course, if demand didn't fall so far that there was no trading, there would still be reductions in consumer surplus, producer surplus, and total welfare.

That's not the end of the story though. The South African government has its reasons for land expropriation and redistribution. South Africa has one of the highest levels of inequality in the world (it's so bad, it even has a dedicated Wikipedia page). Reducing inequality is a worthy goal, and with a bit of luck, this might go some way towards addressing that. So long as they don't follow the example of Zimbabwe, where according to this New York Times story from 2002:

...the government's chaotic and violent seizure of white-owned farms has come at a price. The economy is collapsing. The land program, coupled with severe drought, has left half the population in need of emergency food. And so far, Mr. Mugabe has failed to transform the agricultural sector into a viable system that can feed the nation and drive the economy.

Vast stretches of previously productive farmland are no longer in use because about half of the aspiring black commercial farmers have failed to take up their allotted farms since August, when most white farmers were told to leave.

The government, which seized the farms without compensation, still lacks title to most of the land. Many prospective black farmers are reluctant to occupy farms without title deeds because it is nearly impossible to get loans without them.

Meanwhile, thousands of impoverished, resettled farmers are struggling to survive without seed, fertilizer, irrigation and plowing assistance, basic services that the government has promised.

If South Africa wants to address its inequality problem, land expropriation by itself will not be enough.

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.

Fresh water is not a public good

The title to this post is deliberately provocative, but also entirely accurate. Fresh water has been in the news quite a bit recently, including this article by Kirsty Johnston in the New Zealand Herald today. Johnston writes:

Currently, common law dictates that naturally-flowing freshwater is treated as a public good, or that "no one owns the water".

By definition, a public good is a good that is non-rival (where one person using them doesn’t reduce the amount of the good that is available for everyone else) and non-excludable (where the goods are available to everyone if they are available to anyone). It is the first of these that is clearly not true for fresh water, and this should be clear from the first three paragraphs of Johnston's article:

It was the summer of 1983 when Poroti Springs first ran dry. The watercress stopped growing, the eels disappeared and the koura died, unable to survive as their habitat turned to dust.

Local hapu, the kaitiaki of the sacred Northland springs, were dismayed at the near-extinction of its mauri, or life-force, and the loss of their traditional food source.

The culprit? The Whangarei City Council, who, unable to get to the springhead because it was on Maori land, had drilled directly into the aquifer upstream and sucked up so much water for the town supply, the seemingly endless flow ran out.

Whangarei City Council drew water from the aquifer, and that left less water available further downstream - fresh water is a rival good, not a non-rival good. Goods that are rival and non-excludable are common resources. They are vulnerable to the Tragedy of the Commons, a problem that was first described by William Forster Lloyd in 1833, but was brought to modern attention by Garrett Hardin's 1968 article of that title published in the journal Science.

The problem with fresh water is that all users together (as a group) have an incentive to reduce the amount of water drawn from an aquifer (so that it doesn't run dry). However, no individual user has an incentive to reduce the amount of water they draw by themselves, because the cost of their action is spread over all the water users.

The first problem with the current regime is that many water catchments are clearly over-allocated, or else they wouldn't run dry. Over-allocation of water also has negative consequences for water quality.

One solution for common resources is to make them excludable, i.e. making them not available to everyone. That's what the water usage permits that regional councils issue under the Resource Management Act are designed to achieve. However, giving the permits away for nothing (or next to nothing) is clearly crazy. Johnston writes:

Figures obtained by the Herald found there are now 73 companies with consent to take up to 23 billion litres a year, for an average annual fee of just $200 each.

On a volume basis, that works out at one third of a cent per cubic metres of water (1000 litres). In comparison, an Auckland ratepayer is charged $1.40 per cubic litre [sic] by council, with the rest of the country paying anywhere from 70 cents to $3 to tap into their local supply.

That is ridiculous. Water in all uses should be priced the same. Otherwise, the allocation of water is bound to be inefficient, which is the second problem with the current regime. Although, I will point out that the cost of water drawn at the source (such as by a bottling company or an irrigation scheme) should be less than the cost of water at an urban home or business, because of the cost of the infrastructure (and other costs) associated with getting the water from the source to the home or business. But I very much doubt that the difference in cost is as much as a factor of 200 or more as in the paragraph quoted above.

The lack of a consistent price is not the only reason that the current regime is inefficient. The regional councils' permits create a property right over fresh water, which I wrote about in a post last June. To be efficient though, a property rights scheme has to have four key properties. The rights must be: (1) universal; (2) exclusive; (3) transferable; and (4) enforceable. Here's what I wrote in that earlier post:

Universality means that all fresh water use would need to be included in the system (so municipal water supply, irrigation schemes, industrial use, etc. would all have to have permits to extract and use water). There can be few exceptions to this - although hydro power (where the water is not used up or degraded - that is, its use is not rival, as it doesn't deprive others of also using the same water) may be one.

Exclusivity means that all of the benefits and costs associated with extracting and using the water must accrue to the permit-holder. This essentially means that there can be no free riders - no one benefiting from water who does not have a permit to extract and use that water.

Transferability means that the permits can be freely traded voluntarily. So, if you have a permit to extract and use water from a given river, and you find someone else who is willing to pay more for that permit than whatever you value it at (presumably, whatever value it provides to you), then you should be able to sell (or lease out) your permit. This ensures that water will be used in the highest value activities, and means that water has a price (representing by the price of the permits). Failing to sell (or lease out) a permit entails an opportunity cost (foregone income for the permit holder), so selling (or leasing out) a permit to someone else might actually be the best use of the permit.

The problem with the system that regional councils run is that the permits are not transferable - they can't be sold to those who are willing to pay the most for them. Notice that we've gone full circle now - if the permits were freely transferable, then the price of permits would be set in the market for permits, and all users would face the same price for permitted water allocation.

Fresh water may not be a public good, but it is in the public interest to get this right.

Read more:

• Why we need tradeable fresh water useage rights

The inefficiency of New Zealand's emissions trading scheme

A couple of days ago I wrote a post about the game theory of climate change negotiations. One of the conclusions of that post was that there was a dominant strategy for countries not to reduce their greenhouse gas emissions. Another problem might be that countries reduce emissions, but not by as much as they should (in order to achieve the Paris Agreement goal of no more than two degrees of temperature increase over pre-industrial levels).

Potentially, even worse might be that countries find inefficient ways of meeting their emissions reduction goals, and I believe there is a strong case that New Zealand is in the inefficient camp. New Zealand introduced its emissions trading scheme (ETS) in 2008, and it was later amended in 2009 (and has been reviewed twice since). Under the scheme (described here), "certain sectors are required to acquire and surrender emission units to account for their direct greenhouse gas emissions or the emissions associated with their products".

As Megan Woods notes, one of the main problems with the ETS is that agriculture is not included in the scheme, and farmers have been told that there are no plans to change that in the near future. Agriculture is responsible for about half of New Zealand's greenhouse gas emissions (see page 4 of this fact sheet from NZAGRC).

This creates a problem because, in order to meet the overall goal of emissions reduction, other sectors must reduce emissions by more to compensate. To see why this is inefficient, consider the diagrams below. Say there are just two markets: (1) agriculture (on the left); and (2) all other sectors (on the right). Both markets produce a negative externality, represented by the difference between the supply curve (the marginal private cost or MPC curve, since it includes only the private costs that producers face) and the marginal social cost (MSC) curve (made up of MPC plus the marginal external cost (MEC), which is the cost of the externality to society). In both cases the market, left to its own devices, will produce at the quantity where supply is equal to demand - at Q0 in the agriculture market, and at Qa in the other market. Society prefers each market to operate where economic welfare is maximised. This occurs where MSB is equal to MSC - at Q1 in the agriculture market, and at Qb in the other market.

In the agriculture market, total economic welfare is equal to the area ABD-BFE, and there is a deadweight loss of BFE [*]. In the other market, total economic welfare is GHL-HMJ, and the deadweight loss is HMJ [**]. The value of the externality is represented by the area DFEC in the agriculture market, and by the area LMJK in the other market.

Now consider the implementation of two different emissions trading schemes, as shown in the diagrams below. In the first scheme, both markets are included. Firms must either reduce emissions directly, or buy credits to cover their emissions.  Either of these is costly, and forces the producers to internalise the externality. The markets both move to operating at the point where MSB is equal to MSC, maximising economic welfare at ABD in the agriculture market and GHL in the other market (there is no longer a deadweight loss in either market).

In the second scheme, agriculture is excluded but the same total emissions reduction is desired. This means that the other market must reduce emissions by more to compensate. The other market reduces quantity to Qc (note that the reduction of the value of the externality in this case is double what it was in the first scheme). Total economic welfare in this market reduces to GNSL, with a deadweight loss of NHS. This market over-corrects and produces too little relative to the welfare maximising quantity (Qb). Meanwhile, the agriculture market continues to produce a deadweight loss of BFE.

Notice that the size of the combined deadweight losses across the two markets is pretty much the same under the second scheme (BFE + NHS) than it was without any emissions trading scheme at all (BFE + HMJ). So compared with the first scheme, the second scheme leads to a loss of economic welfare - it is inefficient.

Emissions trading schemes create a property right - the right to pollute (if you have purchased ETS units, you are allowed to emit greenhouse gases). In order for property right to be efficient, they need to be universal, exclusive, transferable, and enforceable. In this case, universality means that all emissions need to be covered under the scheme, and all emitters must have enough rights to cover their emissions. Exclusivity means that only those who have rights can emit greenhouse gases, and that all the costs and benefits of obtaining those rights should accrue to them. Transferability means that the right to emit must be able to be transferred (sold, or leased) in a voluntary exchange. Enforceability means that emissions should be able to be enforced by the government, with high penalties for those who emit more than they are permitted to.

Clearly, the current New Zealand ETS fails under universality as agriculture is not included. And the previous analysis above shows why this leads to inefficiency (loss of total economic welfare). The government is simply passing the buck by avoiding the inclusion of agriculture in the ETS (e.g. see Paula Bennett here). If we want to efficiently reduce our greenhouse gas emissions, agriculture must be included in the scheme.

*****

[*] The total economic welfare in the agriculture market is made up of consumer surplus of AEP0, producer surplus of P0EC, and the subtraction of the value of the negative externality DFEC.

[**] The total economic welfare in the other market is made up of consumer surplus of GJPa, producer surplus of PaJK, and the subtraction of the value of the negative externality LMJK.

Why we need tradeable fresh water useage rights

I've been asked by a couple of students this semester about what I thought about water allocation or a market for fresh water. Interestingly, Basil Sharp (Professor of Energy and Resource Economics at the University of Auckland) wrote a good piece in the New Zealand Herald on that topic today. Sharp wrote:

Creating a market for water use rights would be good for the environment and the economy. It's true to say New Zealand has no overall water shortage. True, but meaningless in practice.

Yes, we are blessed with six times the water per person compared to Australia and 16 times that compared to the US. But rainfall varies geographically and seasonally. Droughts are expected to get longer and more frequent. Ask farmers in Canterbury and Otago, and increasingly in Waikato, if water is scarce.

If water is scarce then it has value. Yet, here's the paradox: water is one of our most valuable natural assets but we don't know its economic value. Successive governments have failed to provide a workable framework that reveals value and enables the exchange necessary for efficient use...

The current system works like this: farmers hold a permit to irrigate their land and can exercise this use right for the duration of the permit. They also have to follow usage rules. Councils can and should monitor use rights and recover compliance costs.

If farmers and other users could transfer their use rights - trade them for money - then the price of water would be revealed. It's already common for water permits to be transferred when land is traded. But what if the opportunity to transfer was freed up? Farmers within a catchment could trade their use rights and trades could occur across industries. They could occur for the duration of the permit, or be leased. This would all take place within sustainability limits.

Essentially, we have a fresh water allocation problem. The problem is that water has traditionally been allocated on a first-come-first-served basis. So, whoever applied for consent to use water first gets to use the water. They cannot transfer that right to others, who may be able to make better (i.e. more value-creating) use of the water. So not only do we have valuable water being used for low-value activities (hands up if you use drinking-quality water to wash your car), but we have no idea how to price water to extract its value (leading to situations like this).

An efficient water rights system (e.g. permits that allow the permit-holder to extract and use a stated quantity of water per year) would need to have a few key properties. The water permits should be: (1) universal; (2) exclusive; (3) transferable; and (4) enforceable.

Universality means that all fresh water use would need to be included in the system (so municipal water supply, irrigation schemes, industrial use, etc. would all have to have permits to extract and use water). There can be few exceptions to this - although hydro power (where the water is not used up or degraded - that is, its use is not rival, as it doesn't deprive others of also using the same water) may be one.

Exclusivity means that all of the benefits and costs associated with extracting and using the water must accrue to the permit-holder. This essentially means that there can be no free riders - no one benefiting from water who does not have a permit to extract and use that water.

Transferability means that the permits can be freely traded voluntarily. So, if you have a permit to extract and use water from a given river, and you find someone else who is willing to pay more for that permit than whatever you value it at (presumably, whatever value it provides to you), then you should be able to sell (or lease out) your permit. This ensures that water will be used in the highest value activities, and means that water has a price (representing by the price of the permits). Failing to sell (or lease out) a permit entails an opportunity cost (foregone income for the permit holder), so selling (or leasing out) a permit to someone else might actually be the best use of the permit.

Potentially, a system like this provides not only for improvements in water allocation, but also improvements in water quality. If your actions are degrading the water quality for permit-holders, you are reducing the value they can extract from the water source, and presumably that loss in value for the permit-holders would be actionable through the courts. So, as well as government-mandated water quality standards, the market could start to provide its own (potentially higher) standards, with failing to meet those standards leading to compensation for other users of the water (which raises the costs of polluting waterways).

However, setting up a system of water use rights or permits does not come without significant challenges. One major issue is how should we decide how many permits to allocate? Do you allocate a number of permits based on the average river flows or aquifer replenishment (of course allowing for the fact that it's unrealistic to take 100% of water)? What happens if flows are below average? Which permit holders will miss out? Do you create some prioritised system of permits, where permits with higher priority can be fulfilled first? However, if you instead take a more conservative approach to permit allocation (based on some lower level of flows), then potentially lots of valuable water simply flows out to sea. Do you instead allocate some additional time-limited permits in years with substantially higher-than-permitted flows?

A second major issue to overcome is how to allocate the initial set of rights. Municipal water supply and other existing users should probably be allocated rights first. But what about other users? What about tangata whenua? Do the remaining rights get auctioned? Who receives the proceeds from the auction (local government, central government, iwi, some other group, or some combination)?

It is clearly time to have a serious conversation about water allocation in New Zealand, because we can do much better. As Sharp concludes:

We have lost 30 years of opportunity. The cost is obvious: water is over-allocated in numerous catchments, patterns of use can't readily adapt to changing economic conditions, and water quality has deteriorated. We can do better for the generation that follows.

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).

Douglass C. North, 1920-2015

I'm a bit late to this due to Thanksgiving-related activities here in the U.S., but Nobel laureate Douglass C. North passed away earlier this week. North shared the 1993 Nobel Prize with Robert Fogel (who passed away in 2013) for "having renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change". North's work led to the development of both cliometrics (the quantitative study of economic history) and new institutional economics.

I use a little bit of North's work in my ECON110 class, where we spend half a topic on property rights and their historical development in western countries. He is also one of the co-authors of the required textbook for that class, which is up to its 19th edition.

Washington University in St Louis has an obituary here, and the New York Times also has an excellent obituary. Tyler Cowen has collected a number of links on Douglass North here.

It is really sad - we seem to be going through a bad few years in terms of the loss of economics Nobel winners.

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.