Archive for the ‘Externalities’ Category

Using whiteboards to teach externalities

July 6, 2017 Leave a comment

In my teaching I am very keen on using whiteboards so that students can get used to drawing graphs and also writing essay plans. It makes it very easy for me to go around the classroom to check on their accuracy and I have to say that the students enjoy the whiteboards even if it does lead to a little doodling. The boards are just over A3 size and are perfect to draw some of the more complex graphs in NCEA and CIE economics. Below are some externality graphs by A2 student Jonathan Ta.


Behavioural Economics and reclining airline seats

June 2, 2017 Leave a comment

I picked up this topic from Michael Cameron’s blog Sex, Drugs, and Economics which looked in detail at the economics behind reclining airline seats. The issue that he refers to is – who owns the space between reclining airline seats?


The person (Recliner) who reclines their seat reduces the amount of space that the person (Reclinee) behind has especially if they have their tray table down and becomes a negative externality to them. Some airlines are worse than others with regard to space – American carriers tend to have very little room as do the low cost airlines. However carriers that operate more long haul flights especially Emirates seem to be more generous with the space between seats. However if there is nobody in the seat behind then there is no externality. This refers to the Coase Theory (see previous blog post) in which Ronald Coase stated that problems are jointly produced by the person who creates the externality and the person who is affected by it. He argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like the scares resource i.e. the space between airline seats.

An article on the site Evonomics by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law) looked at research into how much passengers would be willing to pay to recline their seat. They looked at the following scenarios.

Default – you have the right to recline your seat
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

Default – you don’t have the right to recline your seat and have to negotiate
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.

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.

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

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.

Repeated games may help climate change negotiations

November 22, 2016 Leave a comment

Reading a post from Michael Cameron’s blog reminded me of how repeated games of the prisoner’s dilemma may help climate change negotiations.

The Paris Agreement came in to effect on 4th November this year and it brings all nations into a common cause to undertake take ambitious efforts to combat climate change and adapt to its effects, with enhanced support to assist developing countries to do so.

The main issue with tackling climate change is the cost to countries of implementing it. To be successful it will need profound transformation of energy and transport organisations, and changes in the behaviours of billions of consumers. Research has suggested that it will likely cost 1% of GDP – even though it doesn’t seem much, it is double the amount currently spent on development aid worldwide.

A successor treaty? 

According to Michael Liebreich, the prospects don’t look good when you consider the following:

  • The US sees a cap on carbon emissions as a threat to competitiveness, and hence to its global supremacy. Add to this the rhetoric of President elect Donald Trump which has dismissed global warming.
  • The developing world denounces any calls for a cap on emissions as an effort by former colonial powers to hold back development;
  • Europe has been making encouraging though patchy progress towards targets, driven mainly by a one-off switch from coal to gas.

The issue here is how countries can expect to make cuts in emissions when their economic competitors refuse. This in turn leads to The Tragedy of the Commons which occurs when a group’s individual incentive lead them to take actions which, overall, lead to negative consequences for all group members.

Climate Change as Prisoner’s Dilemma
The initial impression from the discussions over climate change is that of a typical Prisoner’s Dilemma. As mentioned previously, the cost of tackling climate change is approximately 1% of annual per capita GDP. However, if nothing is done about the issue the cost is estimated to be between 5% to 20% of GDP. So that defines what happens at the extreme of cooperative or non-cooperative behaviour.

Climate Change - Pris Dil

Form the table above, a country that refuses to act, whilst the other cooperates, will experience a free-rider benefit – enjoying the advantage of limited climate change without the cost. On the flip side, any country that imposes limits, when its competitors do not, incurs not just the cost of limiting its own emissions, but also a further cost in terms of reduced competitiveness – estimated here at an additional 3.0%.

From the table it seems predictable that countries should prefer to be self-interested: the best national policy, if others reduce emissions, is to defect; likewise, if other countries are not taking action, then it is pointless to be the only sucker to take action, and one should again defect.

Repeated Prisoner’s Dilemma and Cooperation 

The dynamics of the prisoner’s dilemma do change if participants know that they will be playing the game more than once. In 1984 an American political scientist at the University of Michigan, Robert Axelrod, argued that if you play the game repeatedly you are likely to see emerging is cooperative rather than defective actions. He identified four elements to a successful strategy which is this case can be applied to climate negotiations:

1  Be Nice – sign up to unilateral cuts in emissions, as deep as your economy and financing capacity allows.

2  Be Retaliatory – single out countries that have not commenced action and, in collaboration, find ways of pressurising them until they do so.

3  Be Forgiving – when non-compliant countries come onboard give them generous applause; signal that good behaviour
will be rewarded with even deeper cuts in your own emissions.

4 Be Clear – let everyone know in advance exactly how you are going to behave – that you will work with them if they take action on emissions, and that you will retaliate if they do not.

It is the belief of Michael Liebreich that this research by Axelrod should be put into practice by the world’s climate negotiators. As treaties on climate change are on-going and therefore become part of the game.

Final thought 

Repeated Prisoner’s Dilemma provides valuable insight into how countries should act away from the negotiating table and over the longer term. This analysis also highlights the fact that the negotiations themselves are not the game. Diplomats and politicians don’t reduce emissions, engineers and consumers do. However, there are errors in the resemblance as governments can form alliances, which makes the dynamics of the game a great deal more complex. Furthermore, they can act inconsistently and irrationally, and their willingness to act is most probably associated with the harshness of global warming. Ultimately, for the planet’s sake, one hopes that everyone will play the game.


  • The Economist – Economics Focus: Playing with the planet. 29th September 2007 
  • New Energy Finance – How to Save the Planet – Michael Liebreich– 11th September 2007 

Ireland’s first win against the All Blacks – Positive Externalities and loads of Consumer Surplus

November 7, 2016 Leave a comment

ire-v-abs-chicagoYou maybe aware that the rugby game yesterday morning (NZ time) between Ireland and the New Zealand All Blacks in Chicago created history. It was the first time that Ireland have beaten the All Blacks – the closest they got previously was 10-10 in 1973 at Landsdowne Road (the first International that I ever attended).

Irish supporters, including myself, will take great pleasure in talking about such a result – lets face it we lost it in the last few minutes 3 years ago at Croke Park in Dublin. What all this alludes to is the fact that as part of this entertainment comes without the public paying for it, the public benefits from an externality.

Those who flew to Chicago to support Ireland and went to the game will have no doubt spent a significant amount of US dollars tonight in the bars around town. Nevertheless the satisfaction (utility) derived in US$ from the game would have been much greater than the price they paid for the ticket. This suggest that there is a lot of consumer surplus present – the difference between the price that a consumer WOULD BE WILLING TO PAY, and the price that he or she actually HAS TO PAY. The success of the Irish team will boost merchandise sales and interest for the next Test in Dublin but also has been good for rugby in general. When the All Blacks play overseas there are significant externalities whether it be the revenue generated in hosting the match or the social benefits to society. Furthermore the lead up to the game brings about a sense of delayed gratification (Behavioural Economics). The fact that people have paid for their ticket with the game in two weeks time means that they can reap the pleasures of anticipation of being at the game in Dublin. Research (Smarter Spending – see previous post) shows that owning material things from expensive homes to luxurious cars turn out to provide less pleasure than holidays, concerts or even witnessing Ireland beating the All Blacks. With Ireland’s win national pride increases, along with patriotism and people feeling better about themselves. This is turn brings people together and boosts well-being of the nation especially with the current unstable political environment and evidence that the economic recovery is starting to fade – the challenges of Brexit and recent industrial relations.

One wonders what will happen in two weeks time in Dublin but no doubt there will be externalities.

Weaning countries off coal won’t be easy.

September 5, 2016 Leave a comment

Coal UsageGermany, the greenest of green countries, and probably the world’s most enthusiastic investor in renewable energy, is finding it very hard to breakaway from coal fired plants. The German government were all set to impose a levy on the coal industry but instead gave a subsidy of 1.6 billion euros to mothball eight coal-fired plants and shut them down permanently by 2023. The main cause of this change of policy was that there was significant pressure from labour unions and local governments in the coal industry. The resistance in the greenest of green countries is indicative of workers and retirees, local economies and communities still depend on coal.

So from Germany to India, strategies to increase the share of renewable energy in the power mix have relied on a coal base. Although governments worldwide are focused on cleaning up energy sources that cause significant emissions, there needs to be some regard for displaced workers from traditional energy sources like the coal industry. Coal miners skills will hardly be transferable to other occupations – structural unemployment.

Nevertheless, coal remains one of the easiest and cheapest form of energy and this is very apparent in India where usage is about 62% of energy needs. India is the second largest consumer after China and ahead of the USA. Also coal consumption is growing about 7 percent a year to power the country’s economic catch-up. As China is going through a growth period similar to Europe many years earlier, their argument will be that European countries polluted the environment by a similar amount

Climate change activists have highlighted concerns of rising temperatures by 2100, however  are rising temperatures as significant when you consider the long-term implications of much higher unemployment?

Source: New York Times – 30th August 2016

Three Gorges Dam – Positive and Negative Externalities

July 5, 2016 Leave a comment

Below is a very good documentary on the construction of the largest dam in the world – the Three Gorges Dam in China. However in its construction there are both costs and benefits including private and external. This is a topic in Unit 3 of the CIE A2 Economics syllabus and is found under – Externalities. Remember that we have both positive and negative externalities of production and consumption.


 Externalities create a divergence between the private and social costs of production.

  • Private costs are the costs to a ‘firm of producing a good or service and to an individual of consuming a product.
  • External costs are the spill over effects on third parties.
  • Social costs are obtained by adding the private and external costs together. They reflect the total cost to society of an economic decision.

The same concept applies for Private and Social Benefits:


Benefits and Costs of building the Three Gorges Dam

Three Gorges dam - Externalities

The biggest benefit that is seen from the dam’s construction is that it produces renewable energy from hydro electricity. The Three Gorges Dam alone can provide China with 10% of its annual energy consumption. Increasing the proportion of hydroelectricity alternative to coal burning plants, will cut their emissions greatly which will help reduce the overall emissions all over the world – carbon emissions will be reduced 100 million tonnes compared to alternative coal generation

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A Level Revision: Comparing living standards over time and between countries

May 16, 2016 Leave a comment

National income figures, usually GDP at factor cost, are the man figures used to compare living standards. This is because most countries keep and publish detailed national income data.

However, care has to be taken in using national income figures to compare living standards both over time and between countries. It is important to use GDP at constant prices (i.e. real national income) so that a misleading impression is not given because of the effects of inflation. It is also important to take into account differences in population size. A country with a large population is likely to produce more than a country with a small population. However, this output has to be shared out among more people so living standards are not necessarily higher. This is why economist divide output by population and compare real GDP per capita. Even when adjustments have been made for inflation and differences in population size, national income figures as a measure of living standards have to be interpreted cautiously.

A rise in real GDP per capital may have resulted from an increase in the output of capital goods. In the longer run this will increase productive capacity and result in more consumer goods being produced. However, in the short run people may not feel any benefit from more capital goods being made. An increase in weapons will also increase GDP but, again, may not necessarily improve living standards. If more police are employed and crime is reduced, the quality of people’s lives will be improved. However, if more police are employed to keep pace with rising crime, people will be feeling worse off. So economists have to look not only at the amount of goods and services produced but also at the composition of those goods and why the quantity has changed. In addition, the quality of goods and services produced should be examined. The same quantity could be produced this year as last year or five years ago but if the quality of the output has risen, living standards will have improved.

The distribution of income also has to be taken into account. National income may rise but if it is concentrated in the hands of a few, the living standards of the majority may not rise. See graph below from The Economist showing the Gini coefficient of income inequality.

Gini Coef Nordic

National income figures also fail to take into account some items which affect the quality of people’s lives. A certain amount of economic activity is not declared, either to avoid paying taxes or because it is illegal. If there is an increase in, say, people providing home hairdressing services but not declaring them, people’s living standards may rise, although this increase will not be reflected in the official figures.

Differences in working hours and working conditions are also not taken into account. If output remains constant but working hours fall, people are likely to have a higher quality of life.

National income figures only take into account economic activities for which a payment is made. They do not take into account externalities and non-marketed activities. So, for example, an increase in pollution will reduce living standards while an increase in people decorating the homes of old people, on a voluntary basis, will improve the quality of life of the elderly. Neither of these will be recorded in national income figures.

All of these factors have to be taken into account in using national income figures to make comparisons both over time and between countries. However, some additional factors have to be considered when making international comparisons. Different statistical methods are employed in some countries and the degree of accuracy can vary. Tastes and needs can be different in different countries. For example, people living in a cold climate have to spend more on heating than those in warm countries, merely to enjoy the same standard of living. There is also the problem of selecting a rate of exchange to make the comparison. Exchange rate fluctuate and do not always reflect relative prices in compared using purchasing power parities which compare the cost of a given basket of goods in different countries.

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