Externalities, public goods, and property rights revisited: regulations based on traditional B–C analyses are too lax^*

* I would like to acknowledge the useful comments of Ari Rabl, Kerry Smith, and George Tolley, while retaining responsibility for any remaining errors.

ABSTRACT

Pigou advocated for marginal damage taxes on negative externalities, Samuelson described the conditions for optimal pure public goods provision, and both Pigou and Samuelson believed that non-excludability required government intervention/provision, respectively. However, Coase argued that government intervention is sometimes unnecessary. A previously unexplored relationship between externalities, public goods, and property rights implies that non-excludable goods – particularly environmental goods – are undervalued by the methods currently employed by economists. This implies that Pigouvian taxes should generally be larger than currently thought, and that command and control regulations are too lax. The Coase Theorem is seen to have less policy relevance than is typically supposed.

KEYWORDS:

• Externalities
• public goods provision
• environmental valuation
• benefit–cost analysis
• Pigouvian taxation
• Samuelson provision criterion
• Coase Theorem

JEL CODES:

• A1
• A20
• B21
• D04
• D61
• D62
• D78
• H23
• H41
• H44
• J22
• N5
• O44
• Q2
• Q28
• Q51
• Q58

Disclosure statement

No potential conflict of interest was reported by the author.

ORCID

Philip E. Graves http://orcid.org/0000-0002-2833-4702

Notes

* I would like to acknowledge the useful comments of Ari Rabl, Kerry Smith, and George Tolley, while retaining responsibility for any remaining errors.

1 For a readily accessible example, see: https://en.wikipedia.org/wiki/Public_good

2 A better terminology would be a ‘missing market’ rather than a ‘market failure,’ since, as but one example, the steel plant must pay for the labour, capital, energy, and materials to produce steel, but does not pay for its use of air, with clean air going into the blast furnace and dirty air coming out. Per Coase (1960), the zero price on scarce air quality stems from technological difficulties in ‘owning’ air, difficulties potentially resolvable if transactions costs are sufficiently low.

3 The choice of the lighthouse was not ideal as was later made clear by Coase (1974) and Van Zandt (1993).

4 The efficient result being independent of property rights assignment requires negligible income effects (quasi-linearity, in the jargon of economics).

5 A smoker deliberately blowing cigar smoke in the face of a restaurant patron, for example, is not creating an ‘externality’ in the sense that there is no clear policy implication – the preferences (in terms of willingness-to-pay) of the smoker to damage the patron have to be weighed against the preferences of the patron to avoid that damage. It is only inadvertent damage from a smoker to a patron that results in an externality with traditional policy implications. A polluting factory generally is not deliberately polluting in the sense of having willingness-to-pay to damage people. Economists are amoral with respect to preferences and are interested in the welfare of all those impacted by policies, regardless of the nature of those preferences. Usually, apart from the analysis of criminal activity, external damages are unintended, so the distinction is typically not mentioned. Similarly, compensation for the physical spillover (internalizing the externality) also eliminates the externality, with no further policy implications.

Since people only infrequently intend to harm people, physical spillovers from one person to another are likely to be internalized via compensation when considering ordinary goods. If a borrowed tool is broken, the borrower is likely to replace it. It would be extraordinarily unlikely that a neighbour would dump their solid waste over a fence separating an adjoining property. The Coase Theorem is directly applicable to such cases, since property rights are clear and transactions costs are relatively small.

6 She will also generally buy too many ordinary private goods, under independence, equating their marginal values to her lower marginal value of leisure. She will, however, generate the income to buy private good substitutes for the non-excludable goods she cannot buy (e.g. air filters in polluted areas, locks in high crime areas). Hence, if the non-excludable goods – whether rivalrous or non-rivalrous – are produced at the wrong levels, ordinary private goods will also be produced at non-optimal levels. The consumption of low-valued private goods provides another source of resources – in addition to working more hours – to pay for high-value public goods.

7 As noted by a reviewer, there are other ways to attempt to acquire the public goods we desire: lobbying, volunteering, and class-action lawsuits (in a Coase context) come to mind. These alternative activities all suffer from the same free riding incentives that exist for income generation, hence are unlikely to mitigate the undervaluation of environmental goods.

8 Benefit-cost analysis, as currently practiced, uses current income levels under the implicit assumption that overall income generation is optimal, trading off demands for leisure with demands for ‘goods.’ The problem emphasized here is that marginal values of leisure can only be equated to the marginal values of private goods by individual households. As a consequence of being unable to individually increment public goods, both too much leisure and too many low-value private goods are consumed – and this is regardless of how high the value of public goods is at the levels provided by government policy.

9 As the public good is collectively increased, its marginal value will fall. Work effort will increase, but only by the amount needed to fund the public good. Low-valued private goods consumption will fall as will leisure, and utility levels will rise by more than anticipated a priori (see Graves 2017 for more detail, in the context of global warming). It should be pointed out that heterogeneity among households (in preferences, but also importantly in income) will mean that some individuals will have negative net benefits of improved environment, even when there are large overall net benefits of improved environmental conditions.

10 The VCG (Vickrey 1961; Clarke 1971; Groves 1973) mechanisms require quasi-linear preferences, unlikely in general, but of particular concern with free riding in the generation of income. Clarifying, the higher the demand for the non-excludable good, the less income is generated which implies – since income is generated prior to institution of a pivotal Clarke tax – that the tax liability might well be quite large relative to the income generated by a high demander of the non-excludable good. That is, the issue of quasi-linearity relates to endogeneity of leisure (see Flores and Graves 2008 for more detail on the endogeneity issue) while the concern here is about shifts in the work/leisure decision resulting from free-riding).

11 There is some compelling experimental evidence that the WTA-WTP gap is larger for public goods than for private goods (see Horowitz and McConnell 2002). The large size of the WTA-WTP gap has led to a number of ad hoc explanations (e.g. an ‘endowment effect’) but the arguments here suggest that it may be at least partially explained with standard economic theory, combined with input market free riding – the WTP is understated for public goods because income will not have been generated for them since they are not individually incrementable. The arguments here suggest that certain public goods should be increased until the WTA-WTP gap for them becomes similar in size to the WTA-WTP gaps observed for ordinary private goods.

12 As but one example, high-income households on beaches and other low-lying areas often spend a great deal of money outfitting their homes, homes that are destined to disappear in the ocean – yet no one homeowner or group of homeowners, despite their large willingness-to-pay to save houses that cannot be individually saved, has any incentive to generate income to save them (see Graves 2017 for more on this particularly troubling pure public good).