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Climate Change and the Global Externality Problem

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    Introduction: Climate Change

                During the 1980s, the public learned that the earth was supposedly warming. But it was not before the beginning of the following decade that, via the media and the rise of environmentalist political parties, attention was focused on the problem. A first step against global warming was taken in 1992 when many countries (some 166 of them) signed the Convention on Climate Change agreeing to reduce emissions of greenhouse gases to their 1990 levels by the end of that decade. The greenhouse effect is a natural process allowing life to be possible on earth. As its name indicates, it plays the same role as a greenhouse and it is defined as the “trapping of thermal infrared radiant energy in the lower troposphere” (Schneider, 27). As stressed in literature, the greenhouse effect is a natural process not dangerous in itself and even more: essential to life. Without the greenhouse effect, the earth would be too cold for people, animals or plants to live; its average temperature would approximate -20 degrees instead of+15. At the opposite, if a component of the atmosphere permits more solar energy to reach a planet’s surface than it allows radiant heat to escape, the balance between absorption and radiation is lost and the earth warms.

                Greenhouse gases include carbon dioxide, chlorofluocarbons, methane, nitrous oxides and ozone. Like other atmospheric gases, they allow sunlight to reach and warm the earth’s surface, but unlike them, they trap some of the heat radiated back by the earth thereby increasing its temperature, as in a greenhouse. All these greenhouse gases have something in common: they come in part from natural sources but their concentration, and therefore their effect on the climate of the earth, has increased rapidly since industrialization. On the contrary, the chlorofluocarbons (CFCs) are the only purely man-made chemicals among the greenhouse gases. They are mostly used for refrigeration, air conditioning, aerosols and solvents and contribute some 20% of global warming. Because they also attack the ozone layer, they are now heavily restricted since the Montreal Protocol. The problem they cause has however not disappeared because i) not all countries signed the Protocol, ii) they are still used for some activities, iii) their molecules have 20,000 times the heat trapping effect of a molecule of CO2 and iiii) they have slow decay rates.

                The general scientific consensus is that the major instrument of climate change is the increase of carbon dioxide concentration mostly due to the burning of fossil fuels and to a lesser extent deforestation. This is not to say that aerosols, air conditioning, rice paddies, volcanic activities (via a change in the CO2 concentration), other sources of greenhouse gases, or even the sunspot cycle, do not contribute to global warming, but they are less important as causes of climate change.  By the burning of fossil fuels in the manufacturing or transportation sector or at home, the whole world is releasing the huge amounts of carbon stored in fossil fuels over millions of years. Since carbon dioxide absorbs and conserves heat given off by the earth, society is speeding up and distorting the natural carbon cycle thereby intensifying the greenhouse effect and turning it into a planetary menace (Schneider, 29).  In one word, the chief cause of human-induced climate change is 200 years of ever-increasing fossil fuel use.

                In the medium and long run, the greenhouse effect will alter the current environment, enhance natural disasters and require that human activities be adapted to it. These will be the results of a rapid climate change.  The most probable impact of worldwide warming is certainly sea level rise. Glaciers and polar ice caps will melt as temperature increases. Moreover, even if the emission of greenhouse gases were to end immediately, sea level will still rise in the future because of the lag between greenhouse gas concentration and temperature change and the reaction of oceans and ice sheets. Since many countries, like the Netherlands, Bangladesh and Egypt for example, have much population clustered around a river or a sea, a generalized sea level rise may cause damages to urban infrastructure and a necessity of either relocation or construction of adequate protection.

                Climate change or global warming is a global externality since, by extending its use of the common property resource – the atmosphere – as far as it is beneficial for itself and without regard for the consequences it brings about to others, every nation imposes an uncompensated external cost on other countries. There is also a reciprocal characteristic to this externality because all polluting countries damage themselves and others by emitting greenhouse gases into the atmosphere.

                A domestic externality can be internalized by a properly designed tax or other economic instruments but a global (or international) environmental problem can only be solved by cooperation, that is to say by ratifying a voluntary agreement among countries concerned.

    Externalities, Market Failure and Overpollution

                An agent is said to create an externality or an external cost (or benefit) if his activity causes an unintended or incidental loss (or gain) of welfare to another agent and if the loss (or gain) is uncompensated. This definition can be applied in a domestic as well as an international context; in the former, “agent” will be thought of as a firm or a consumer and in the latter, as a nation or a group of countries. Hence, domestic and transnational pollution are externalities. The steel mill creates an external cost by polluting the river since it does not compensate the fishery for damages caused. Similarly, a country emitting greenhouse gases in the atmosphere does not take into account the costs of environmental degradation it imposes on others.

                Externalities have basically five characteristics. First, they can either be positive or negative depending on whether the activity of an agent increases or decreases the welfare of others. It follows that pollution is a negative externality. Secondly, they can be classified as consumption or production externalities if the choice of an individual directly affects a consumer’s utility or a producer’s production function respectively. This means that, by polluting the river, the steel mill creates a negative production externality for the fishery. They are either marginal or inframarginal. A change in the level of the activity generating the externality has an impact on a marginal but not on an inframarginal externality. The steel mill is a marginal externality because a change in the discharge into the river affects the number offish to be captured; and so is global warming because the change in greenhouse gas emissions has an impact on the variation of temperature. The steel mill externality is qualified as a technological as opposed to a pecuniary externality (where the effect is transmitted through price changes) (Baumol and Oates, 119). Since greenhouse gases are associated with a public good (atmosphere), global warming is a technological externality communicated through the area of public good.

                These two last properties can be detailed a bit more. Domestic or transnational pollution is a public good -or “bad”- externality because it has the character of a public good: it is non excludable and undepletable. Pollution is indeed non excludable in the sense that it is accessible to all, that everybody can “consume” it. Moreover, a person’s “consumption” of pollution does not decrease the amount available to others, which satisfies the undepletable character of the public good. At the opposite, a private externality involves a depletable good.

    It can also be claimed that pollution is a technological and not a pecuniary externality. The difference is important because the latter does not produce a misallocation of resources whereas the former does (Baumol and Oates, 137). Going back to the definition of externality, it is stated that the agent generating an externality imposes a cost or a benefit on others without compensation because he does not take into consideration his actions on the welfare of other individuals. Thus there exists a divergence between the private cost or benefit faced by the affecting agent and the social cost or benefit associated with his activity. This creates an economic inefficiency or a market failure: Pareto optimality will not result from the market mechanism because the agent generating the externality will equalize its private cost and benefit instead of its social cost and benefit.

                Since pollution, as a negative technological externality, creates a market failure, the same should be true if it is characterized as a public good externality. It indeed is, and as Varian stresses, it is due to the free rider problem (Varian, 201). As a matter of fact, every individual is tempted to let others pay for the provision of the public good or the elimination of the public bad without contributing himself since everybody will have full use of the service if it is acquired. Hence, in general, purely individualistic mechanisms will not generate the optimal amount of a public good or bad.

                Pollution is thus a negative public-good externality and it induces a market failure. This is so both in the domestic context and the transnational context. However, two further remarks should be added for transborder externalities. First, as Varian points out, categorizing international externalities might not be straightforward because in some cases, they represent both production and consumption externalities and moreover, either firms or consumers can be the cause (Varian, 209). Acid rain for example, affects agricultural output (production externality) and healthy fish which might provide direct utility to some people (consumption externality) and power plants (firms) as well as motor vehicles (consumers or firms) might be the cause. This example can be easily applied to global warming. Greenhouse gases affect agricultural output (production externality) but also human health that provides direct utility to everybody and essentially to athletes (consumption externality) and they are emitted by firms (via the burning of fossil fuels and deforestation) as well as people (via CFC use for example). However, it is not a crucial fact in this analysis of reciprocal pollution because, even though not totally, acid rain and greenhouse warming are mostly recognized as production externalities.

                The second remark comes from Maler who correctly notes that international externalities might have no physical effects at all, that is no flow of materials or energy transported from one country to another (Maler, 53). Global warming is clearly a physical externality: the transboundary effect is the temperature change caused by greenhouse gases but an example of a non physical transboundary effect might be the general concern for the preservation of wildlife (whales and elephants, for instance).

                In order to find ways to eliminate the allocative inefficiency of an externality like the emission of greenhouse gases one should beforehand understand why an externality arises. This can be done by examining the notion of property rights. By definition, they emphasize an excludability mechanism and according to Tietenberg, they “refer to a bundle of entitlements defining the owner’s rights, privileges and limitations for the use of the resource” (Tietenberg, 331). Given a legal system which recognizes private property, the market brings about an efficient allocation. This is intuitively obvious because prices are determined by the value of efficient use, thus penalizing inefficient users. More formally, the consumer decides how much to purchase by maximizing his individual net benefit (consumer surplus) and so does the producer. The total benefit is maximized (it is the sum of the consumer and producer surplus) and the market clears. When, however, property rights are improperly designed or do not exist in whole or in part, the excludability feature disappears; an externality arises and the resulting allocation is inefficient. As a matter of fact, such rights cannot be determined for the global warming problem because greenhouse gases are emitted into a common property resource (the atmosphere), they involve a public bad (polluted air) and neither the common property resource, nor the public bad presents the excludability feature.

                Of course, common property resources, or the commons, can refer to domestic, international or global resources for which no property rights have been awarded or in other words to those resources not exclusively controlled by a single agent or source. For example, a public field where cows graze is a domestic common property, the Baltic sea is international common property and the atmosphere is part of the global commons. Transnational pollution of the commons is almost always a reciprocal externality and the concern is that, because of its free access and because it is finitely available, the common resource is likely to be overused. Let us develop this idea in the context of the greenhouse effect.

                Every single country in the world freely emits greenhouse gases into a common property resource, the atmosphere. It is a reciprocal externality since the decision by any country to pollute will cause repercussions on all other nations as well as itself. Of course, the atmosphere is a renewable resource capable of regenerating itself, but the higher the pollution and the longer pollutants are active, the lower the speed of regeneration. In other words, if nations of the world pollute at such a high rate that the atmosphere is not able to regenerate itself anymore, the renewable resource is in danger of extinction. And that is precisely what the risk is because it is beneficial for all nations to overuse the atmosphere: a scarce renewable resource. As a matter of fact, each nation is likely to extend its use of the commons as far as it is beneficial for itself, and without regard for the consequences to the others. And conversely, no country has an incentive to conserve and use the resource efficiently because it would thereby subsidize the welfare of other nations.

    Hardin described this problem in his very well known article “The Tragedy of the Commons” and he even went further by stating that “freedom in a commons brings ruin to all” because each man is locked into a system that compels him to increase his pollution without limit in a world that is limited (Hardin, 1245). Hardin took the example of a herd grazing on a common pasture and concluded that it is always profitable for each herdsman to add another animal; but in pursuing his own best interest, he will bring ruin to all because the pasture is limited in size and nutrients and will finally become extinct. Dasgupta criticized Hardin by underlining that animals are not costless and that “such private costs set limits on the number of animals each herdsman finds most profitable to introduce into the common pasture” (Dasgupta, 55). Nevertheless, the important point here is that a common property resource is likely to be overused, and this is so even if costs are taken into account.

    Cooperation and Policy Options

                In the global warming context, the general aim of preventive policy option is to cut fossil fuel emissions by decreasing the consumption and/or production of carbon-based energy products (like oil, coal and natural gas) and refraining from tropical deforestation. This will at least slow (and hopefully stabilize) the buildup of atmospheric carbon dioxide and the level of externality will thus be reduced.  Various policy instruments can internalize a domestic externality. The two most widely recognized options are probably the emission tax and the emission standard (quota). But in the presence of a transnational externality, it is generally not feasible to impose these instruments on all nations involved because of the lack of a central authority or a global government and because no country has the right to impose a tax or a direct regulation on another one. Therefore, for the greenhouse effect as well as for any other transnational reciprocal pollution problem, cooperation is the only method capable of improving the environmental quality and reducing the externality generating activity. This, however, does not mean that the classic instruments to combat pollution are useless. It simply signifies that in view of the global characteristic of climate change, preventive policies require some form of agreement between a large number of countries in order to be effective (because the higher the number of nations, the greater the impact). And when a target or a plan of action is commonly agreed upon during the negotiation process, participating nations have an obligation to comply with the agreement but stay sovereign in their selection of a policy measure that would meet the target.

                It is not true if a globally identical carbon tax is agreed upon for example. This is seriously considered in the literature by various authors, including Whalley and Wigle and Dombusch and Poterba, but the chance for such a tax to be unanimously accepted is small because it is a simplification that is too much disconnected from reality (Whalley and Wigle, 235; Dombusch and Poterba, 315). As a matter of fact, some countries may prefer another instrument than a tax mechanism, but above all no country could accept a tax that it did not decide for itself. Moreover, as Dombusch and Poterba underline, there are three major problems for such a tax (Dombusch and Poterba, 316-318). First, there is no built-in mechanism to make the distribution of burdens satisfactory. Second, it is not clear what such an agreement of harmonizing CO2 taxes implies, in particular if some of the participating countries are non market economies. And finally, the free rider problem is such that it is in the interest of each country to try to make this tax as ineffective as possible, for example by taxing close substitutes to fossil fuels (e.g. hydroelectric power) and subsidizing complements (e.g. automobiles) so that the cost of the CO2 tax is reduced.

                The measures that can be considered include a ban on fossil fuels, scientific methods, the “no-regrets” policy, the extension of property rights, emission quotas, tradable permits, carbon taxes and trade options. It is important to note that these policies are neither exhaustive nor exclusive. It means that they can be mixed together or supplemented by other options. For example, if it is technologically and economically feasible, a carbon tax can be coupled with a reforestation policy and/or an accentuation of renewable energy use in a particular industrial country; and a limit on deforestation alone can do the job of reducing the externality to a commonly agreed level in a tropical country. If no agreement is reached whatsoever, either because of the remaining uncertainties or another reason and if no incentives in the form of side payments are given to reluctant countries, the outcome might result in some scattered unilateral abatements with very little worldwide impact or in adaptation, like changing agricultural practices or building higher dams because of the sea level rise, to the new situation when climate change occurs.

                The first prevention measure, and the strongest one, consists of a complete ban of greenhouse gases. The underlying reason for this option is very simple. Since greenhouse warming is mostly a byproduct of fossil fuel combustion, their use should be forbidden. Currently, this option is not to be considered. First, fossil fuels are the cheapest source of additional energy and they are critical for the energy sector of all economies. Proscribing them would imply a vast reliance on nuclear and solar energy (or other renewable energy sources) with much higher cost. Hence, it might introduce a worldwide recession and anyway, it would be totally inefficient from an economic standpoint. Moreover, other non economic problems may arise.

                Scientific techniques could also be used as a preventive measure. The goal is to find a way for removing carbon dioxide from fossil fuel plants or from the atmosphere or to introduce a counteracting cooling mechanism in order to compensate for the accumulation of fossil fuel emissions and their potential warming. It is very unlikely that the latter option could currently play a role.  If every country agrees to contribute by a little amount, the situation can slightly improve in a non costly manner (i.e. marginal costs are low for the first increments of abatement). This roughly defines Nordhaus’ “no-regrets” policy (Baumol, 218). It is called “no-regrets” because its aim is to slightly reduce greenhouse gas emissions with no (or very little) additional costs; and therefore, no country would regret the adoption of such a policy measure. It involves conservation, research and development for non fossil fuels, a small decrease in CO2 emissions and the implementation of CFC restrictions defined in the Montreal Protocol. These actions will help cleaning the atmosphere and they will indeed only impose a small additional cost to participating countries.

                As long as too many uncertainties and/or disagreements remain, this is a very good first step. In the longer term, however, two cases should be considered. First, if the GCMs are right and a warming is really occurring (or will soon occur at the expected magnitude), the global impact of such a policy is likely to be very much insufficient. And even if temperature does not significantly increase in the future, it is fair to say that, making abstractions of the costs and benefits involved, a tougher policy might not be useless: it will indeed improve environmental quality and energy security because of the link between greenhouse gases, air pollution and oil security.

                “Command-and-Control” instruments are the most widely used in environmental regulations. The use of emission quotas for carbon dioxide is an example of this kind of instrument. They may take the form of a restriction for the carbon content of individual fuels, that is, since oil contains more carbon than natural gas per unit of measurement and less than coal, the maximal amount of tons of oil produced will be set at a smaller level than natural gas and at a higher level than coal. Quotas are widely used and they may be one of the most likely policy measure for dealing with the greenhouse effect. The Montreal and Kyoto Protocols is a good illustration for this. Quotas may be uniform or based on each country’s baseline emission (the base being the aggregate emission for a particular year or a yearly average emission for a predetermined period). This may cause conflicts between nations and induce a relative inequity. For instance, less developed countries would not accept stringent measures since their main preoccupation is to enhance economic growth France would not agree because by adopting nuclear energy, it already eliminated proportionally more carbon dioxide than other industrialized countries (or put in economic terms, France’s marginal cost of abatement is now higher than some other industrialized countries).

    Works Cited

    1. Baumol, W. and W. Oates, The Theory of Environmental Policy, Fifth Edition. Cambridge University Press, 2003
    2. R. Dombusch and J. Poterba: Global Warming: Economic Policy Responses”, MIT Press, Cambridge MA, 1991
    3. Dasgupta, P.  “The Environment as a Commodity”, Oxford Review of Economic Policy, Vol.6, No.l, p.51-66, 1990
    4. Maler, K.G.  “International Environmental Problems”.  Oxford Review of Economic Policy, Vol.6, No. 1, p.51-67, 1990
    5. Hardin, G. “The Tragedy of the Commons”. Science, Vol. 162, p. 1243-1248, 1968
    6. Schneider, Stephen H. Global Warming: Are We Entering the Greenhouse Century? Sierra Club Books, San Francisco, CA, 1989
    7. Tietenberg, T.  Environmental and Natural Resource Economics. Fourth Edition, Glenview, IL: Scott, Foresman and Company, 1998
    8. Varian, H. Intermediate Microeconomics: A Modern Approach. Seventh Edition, New York,    NY: Norton, 2005
    9. Whalley, J. and R. Wigle “The International Incidence of Carbon Taxes” in R.Dombusch and J. Poterba: Global Warming: Economic Policy Responses, MIT Press, Cambridge MA, p.233-262, 1991

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