Environmental Externalities and Their Internalization Through Voluntary Approaches

Abstract

In this chapter it is explained how the optimal pollution level can be determined in an elementary model in which the emissions of a single polluter harm a single “victim.” In particular, it is shown how this optimal outcome might in principle be accomplished by bargaining between the polluter and the victim, but there are many obstacles preventing the success of such Coasean bargaining. The chapter also discusses other voluntary approaches for the internalization of environmental externalities, especially for the case of multilateral externalities where several polluters harm each other.

Appendix: Multilateral Externalities, Public Goods, and Mixed Goods

Until now we have only dealt with the case of a downstream, i.e. a unidirectional, externality where there is a clear distribution of roles between the polluter and the victim. Yet, in many cases of empirically relevant environmental problems, agents are affected both by the emissions of all other agents and by their own pollution, so that essentially everyone at the same time is a polluter and a victim. A prominent example for such a “multilateral externality” is climate change where the emission of greenhouse gases by car drivers or consumers of fossil-fuel-based electricity contributes to global warming and thus harms the emitters themselves like anyone else. Around the globe, there is non-rivalry and non-excludability (see ► Box 2.3 below) in receiving the adverse effects of global warming, and hence this warming due to the emission of greenhouse gases is a global public bad.

To describe this situation in a model, we assume that there are two agents A(dele) and B(ridget). Each of both uses fossil fuels and thus reduces environmental quality for herself as well as for her counterpart. Analogously as before in the case of a unidirectional externality, the material benefit from their own environmentally damaging activity x_i is denoted by B_i(x_i) for agents A and B, respectively. However, now the environmental damage that A and B suffer depends both on her own pollution and the pollution caused by the other agent. Hence, agent A’ s environmental damage function is D_A(α_AAx_A + α_BAx_B), and that of agent B is D_B(α_BBx_B + α_ABx_A) where α_ij(i, j = A, B) indicate the impact of both agents’ emissions on the environmental quality enjoyed by them. If α_AA = α_BB = α_BA = 0, but α_AB > 0, the case of a unidirectional externality is obtained as a special case of this general model, in which agent A is the polluter and agent B the victim. In the following, we focus on the case α_AA = α_BB = α_AB = α_BA = 1 where the environmental impact of both agents’ emissions is completely symmetric so that pollution becomes a true “public bad.” Henceforth, abatement is a “public good,” which simply means that abatement activities (= reductions of the polluting activities x_i) have the same effect on environmental quality for each agent irrespective of where abatement efforts take place. If both agents act independently in this situation with reciprocal externalities, they will – according to the Nash hypothesis – adapt their own emission level to that of the other agent, i.e. agent A maximizes her total benefit B_A(x_A) − D_A(x_A + x_B) for any given x_B by choosing x_A, while agent B analogously maximizes B_B(x_B) − D_B(x_A + x_B) for any given x_A. In this case the non-cooperative Nash equilibrium, i.e. the laissez-faire solution with activity levels ${\overline{x}}_A$ and ${\overline{x}}_B$, is attained when the reactions of both agents coincide, i.e. the two marginal conditions ${B}_A^{\prime}\left({\overline{x}}_A\right)={D}_A^{\prime}\left({\overline{x}}_A+{\overline{x}}_B\right)$ and ${B}_B^{\prime}\left({\overline{x}}_B\right)={D}_B^{\prime}\left({\overline{x}}_A+{\overline{x}}_B\right)$ simultaneously hold. The optimal activity levels ${x}_A^{\ast}$ and ${x}_B^{\ast}$ that maximize aggregate welfare (B_A(x_A) − D_A(x_A + x_B)) + (B_B(x_B) − D_B(x_A + x_B)) of the two agents instead are characterized by the marginal conditions ${B}_A^{\prime}\left({x}_A^{\ast}\right)={D}_A^{\prime}\left({x}_A^{\ast}+{x}_B^{\ast}\right)+{D}_B^{\prime}\left({x}_A^{\ast}+{x}_B^{\ast}\right)$ and ${B}_B^{\prime}\left({x}_B^{\ast}\right)={D}_A^{\prime}\left({x}_A^{\ast}+{x}_B^{\ast}\right)+{D}_B^{\prime}\left({x}_A^{\ast}+{x}_B^{\ast}\right)$. For aggregate polluting activities of both agents, we then have ${x}_A^{\ast}+{x}_B^{\ast}<{\overline{x}}_A+{\overline{x}}_B$, i.e. that – not quite surprisingly – aggregate emissions in the optimal solution are lower than in the laissez-faire outcome. This follows by an indirect proof: Let us assume that ${x}_A^{\ast}+{x}_B^{\ast}>{\overline{x}}_A+{\overline{x}}_B$. Then it follows from ${D}_i^{{\prime\prime}}\left({x}_i\right)>0$ that ${B}_i^{\prime}\left({x}_i^{\ast}\right)={D}_A^{\prime}\left({x}_A^{\ast}+{x}_B^{\ast}\right)+{D}_B^{\prime}\left({x}_A^{\ast}+{x}_B^{\ast}\right)>{D}_i^{\prime}\left({\overline{x}}_A+{\overline{x}}_B\right)={B}_i^{\prime}\left({\overline{x}}_i\right)$ would hold for both agents i = A, B. Since ${B}_i^{{\prime\prime}}\left({x}_i\right)<0$ this, however, would give ${x}_i^{\ast}<{\overline{x}}_i$ for i = A, B and thus a contradiction.

In principle, internalization of reciprocal externalities is conceivable by the same voluntary approaches as in the case of unilateral externalities, i.e. through bargaining and matching. Both theoretical modelling and practical implementation of these approaches are getting much more complicated in the case of reciprocal externalities. Yet, in the context of global public goods, as in particular climate change mitigation, overcoming suboptimal provision is not possible without bargaining between states as there is no international coercive authority that could enforce globally efficient climate protection regulations. Hence, the voluntary approaches are of much importance in this field. That especially norms may play a dominant role for successful collective action on voluntary public goodprovision is stressed by Nobel laureate Elinor Ostrom. “Increasing the authority of individuals to devise their own rules may well result in processes that allow social norms to evolve and thereby increase the probability of individuals better solving collective action problems” (Ostrom, 2000: 154). We will later come back to these issues in ► Chap. 5.