A solution for external costs beyond negotiation and taxation Alexandre Magno de Melo Fariaa Hélde A. D. Hdomb aFederal University of Mato Grosso F aculty of Economics. Brazil.

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A solution for external costs beyond negotiation and taxation

Alexandre Magno de Melo Fariaa Hélde A. D. Hdomb

aFederal University of Mato Grosso, Faculty of Economics. Brazil.

bUniversity of Beira Interior, Portugal

Abstract

This article aims to launch light on the limitations of the Coase and Pigou approach in the

solution of externalities. After contextualizing the need for integration of ecological and

economic approaches, we are introducing a new conceptual proposal complementary to

conventional economic approaches. Whose process is guaranteed by a set of diffuse

agents in the economy that partially reverses entropy formation and marginal external costs

generated by also diffuse agents? The approach differs in six fundamentals from traditional

theory and proposes a new way of examining the actions of agents capable of reducing

entropy and containing part of external costs in the market economy.

Keywords: Coase-Pigou, External Cost, Negative Externality, Reverse Externality.

1. Introduction

The beginning of the 21st century has been marked by transformations that are directly or

indirectly interconnected through the various problems that society, and the economy and

technological development, and the environment are as their main drivers of these

transformations. In particular, the energy consumption by humanity to run the economy of

countries (Hdom and Fuinhas, 2020). These transformations have been increasingly

accentuated since the first meeting of nations at Rio 92 to discuss the relevance of

sustainability policies for the world to continue its development without compromising the

survival of human beings on the Planet. Since then, technological transformations through

innovation policies and energy and economic efficiency have been the subject of

increasingly appropriate investigation. Therefore, this entire relationship between economy,

human beings, ecosystems, and the environment is an increasingly important source of

analysis. In this work, we focus on interactions that the economic system is primarily

responsible for, and its direct or indirect impact entails a series of general or

macroeconomic problems. Thus, a new theoretical assessment approach is launched to fill

a gap in this relationship mediated by positive and negative externalities.

For example, the research provides a new theoretical framework to support researchers in

rotating fields such as Environmental Sciences, Environmental Economics, Ecological

Economics, Energy Economics, Natural Resource Economics, and Social Sciences, not

limited to this scientific area group, more to all those who make use of science to improve

the understanding of the impacts of human and economic actions and activities on the life

and well-being of society. That is the search for balance between environmental, social,

and economic forces, whose interactions the economic system is responsible for. The

method involves the precise analysis of the development of externalities in the economy

and the determinants of behavior change during the process of extracting resources for

manufacturing, trading, consuming, and disposing of economic goods. In this scenario, the

research facilitates the understanding of the impacts, and the results are extremely relevant

to the Energy, environmental, and economic nexus. Especially related to the addition of the

theme of renewable energies, energy security, and the strong reduction of emissions for

the Low Carbon economy. In addition, it helps to guide future empirical research in the

search for answers to problems related to externalities. In other words, this work takes a

different path from the conventional or unsustainable point of view of economics to

improve the understanding of the reverse impacts of externalities.

Unprecedented, the world is simultaneously experiencing a global health crisis along with

economic and environmental problems. There is neither consensus, and also a quick fix to

stabilize global warming at 1.5 °C as detailed in the Paris Agreement. However, the

COVID19 pandemic especially revealed that the loss of life far outweighs the economic

benefits in the humanitarian context. Whilst, in the economic context the data showed a

sharp retraction in productive activities due to the impacts of the global health crisis. At the

same time, CO2 emissions and other pollution factors also drastically decreased in the

environmental context during the isolation peak. The reality of the Global Pandemic has

forced politicians, country governments, and policymakers to rethink the sense of priority

(the lives of people, citizens, or profit and economic growth). However, the open debate

seems to lead to a well-known path, that is "degrowth" and the "energy transition" as a

reply to tackles the problem by parts. Which of these parts is the best choice will depend

largely on the benefits associated with each of the alternatives. Another problem is that if

the degrowth alternative can be a way to delay the climate crisis responding to the

generational effect, this alternative can mean, to some degree, not only the worsening of

people's living conditions. But also, the corresponding gap between poverty and wealth,

impacting the aggregate effect. Alternatively, the energy transition poses enormous

challenges, but it is more real than considering a utopian hypothesis. This is:

- How much of the world's GDP needs to decrease to have a minimum level of climate and

energy security?

- Furthermore, how much of this decrease can be distributed among rich, emerging, and

poor countries until the complete transition from fossil energy to renewable energy?

These are pressing questions that the search for answers can help the set of results

explained by modern economic models.

Our analysis proposal is based on well-known literature, i.e., we launch the proposal to

investigate these phenomena through an intrinsic relationship of positive and negative

externalities, drawing a parallel simultaneously. For example, pollution imposes a cost on

society. That is the loss of biodiversity, climate change, and other effects that bring costs to

societies. A major problem has been the depletion of natural resources, which played a

double role in the development of countries (Hdom et al., 2019). This is because the

depletion of natural resources causes a negative change in the natural environment and

because the natural resources extracted to carry out economic production generate waste

(pollution). This dual role is theorized and explained by theories such as Natural Resources

and traditionally that of externality, among others linked to the investigation of the effects of

the economy on the environment.

In this sense, we have divided the work into six parts, in addition to the introduction, the

second part sheds light on the limitations of Coase and Pigou's approach in solving

externalities. In the third part, we contextualize the need for integration of ecological and

economic approaches, and finally, in the fourth part, we present a new complementary

conceptual proposal. In the sixth part, the conclusion and limitations of the research are

provided.

2. Background

The debate about externalities is found in “Principles of Economics” by Marshall (1890)

when the author mentions a process for the formation of external economies. This

approach is well established within the welfare of the Neoclassic economy, considering the

ethos of economic agents which maximize their benefit in a market. Where the agents seek

to decide the better strategies for their well-being through the utility that can be achieved.

The individual decisions would not include positive or negative reactions to third parties,

but only selfishness capable of maximizing its benefits. For economic theory "the economic

model of consumer behavior is very simple: people choose the best products they can

afford to pay for." On the other hand, for Alfred Marshall, a decline in the average

production costs of a company may be possible obtain, when generated by economies

external to the firm, but internal to the industry. (e.g., technical innovations and information

exchanges) can generate positive external economies, and the greater the general

development of the industry, a positive impact on third parties is generated, but it is not

perceived ex-ante or ex-post to a decision.

To Marshall external economies are not generated internally in firms, but internally in the

industry. The larger is the concentration and sharing of information, the bigger are the

external gains. This phenomenon is often referred to as Marshall-Arrow-Romer externalities

(Sahdev, 2016). There is also another perception of this phenomenon, known as,

urbanization economies, which regards the decrease of operating costs derived from the

spatial concentration of multiple and diverse interdependent activities. In this process,

urbanization economies are external to a firm and the industry, instead generated in other

related activities, yet that reduce the overall costs because of systemic interaction. Such

economies are referred to as Jacob’s externalities (Jacobs 1969).

The second approach that affected deeply the externalities debate arose in Cambridge,

with Pigou (1920) In this work “The Economics of Welfare”, Pigou develops important

contributions to economic decisions to advance the welfare of a community. Among

others, one of his main concerns was based on actions to raise the income of a nation. An

alternative would be de the displacement of inefficient resources. Generally, industries are

interested, not in the social, but instead in the private liquid product of their stocks.

Regarding moving costs, self-interest will tend to generate equality in the marginal private

liquid product of resources invested in different ways. However, it will not tend to generate

equality in marginal liquid social products, except when marginal private liquid product and

marginal social liquid product are identical. When there is a divergence between these two

types of marginal liquid products, self-interest will not tend to maximize the national

product; and therefore, it is expected that certain specific acts of interference in the normal

economic processes do not diminish but increase the product (Pigou, 1920).

In this sense, in seeking explanations for external economies, Pigou defines the marginal

social liquid product and marginal private liquid product. Maximizing national dividends

could only be achieved when there was an identity between the two marginal liquids

products. In the presence of differences, Pigou believed in the existence of externalities that

would affect the economic agents' ability to achieve maximization, even in competitive

markets. The solutions for externalities could include the presence of fines, restrictive

contracts, subsidies, and taxes that the government could implement to re-balance the

marginal private product with the marginal social product (Pigou, 1920). Knight (1924)

criticized Pigou for does not agree with the concept of external economies and believed in

market forces to appropriate the underlying economic effects of fluctuations in production

costs. In this analytical framework, Knight believed in the free market to drive the economy

to a higher level. No corrective actions to externalities were necessary.

For Daly and Farley (2010) Knight discussed in his article, “Risk, uncertainty and Profit”

(1921), the case in which entrepreneurship supported the costs of failure and reaped the

fruits of success, but in the case of exploitation of ecosystems often the entrepreneur

appropriated the benefits and society bear the costs. A clear formation of negative

externalities from the action of private agents oriented to profit. The interesting article by

Ronald Coase, “The problem of social cost” (1960) recovered the discussion regarding

externalities. For Coase, the problem of externalities should not have solely a marginal

approach as Pigou pointed out, but also one regarding its global effects. Even finding a

solution at the individual level to penalize agents for the negative effects generated, the

correction could not produce the best results at the aggregate level: “The real problem to

be solved is: A is allowed to damage B or B is right to harm A? The question is “how to

avoid the most intense damage” (Coase, 1960).

Coase launches a new awareness solution, arguing that externalities are due to a lack of

market and well-defined property rights. In his perception, the correct functioning of the

market would ultimately lead to the final allocation of resources at the same level, even

with externalities and regardless of whether the cause assumes or not its costs. For Coase,

the Pigouvian solution of taxation, subsidies, or intervention does not necessarily raise the

well-being of society. Coase further argues that one should seek the optimal solution

because it believes that the benefits of removing the externality must be greater than the

transaction costs to promote adjustment. That is to say that, not always the best solution is

to tax the causer of the negative externality, the compensation for the loss, and disregard

the market conditions in which are the involved agents. Direct negotiation or a clear

definition of property rights could minimize transaction costs and increase the generated

social benefit. On the other hand, when externalities achieve several agents that tend to

infinity, the problem and the solution becomes complex.

Transaction costs can be prohibitive, interests and conflicts can be sharp, and agents

cannot recognize the solution instances. When the costs tend to infinity and social benefits

are more affordable than the cost of the transaction, the State becomes a key player in the

resolution, following the Pigouvian line. Therefore, in more localized or well-established

property rights disputes, the Coasean trading solution with low transaction costs can be an

alternative to the internalization of externalities. In a larger arena, with systemic externalities,

high transaction costs, and possible strategic actions, solely the performance of supra-

individual representation like the State can reduce the externalities with an acceptable

transaction cost.

3. Definitions of the microeconomics

Microeconomics textbooks reserve to externalities a section regarding “market failures”. In

said section, along with information asymmetries, public goods, incomplete markets, and

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AsolutionforexternalcostsbeyondnegotiationandtaxationAlexandreMagnodeMeloFariaaHéldeA.D.HdombaFederalUniversityofMatoGrosso,FacultyofEconomics.Brazil.bUniversityofBeiraInterior,PortugalAbstractThisarticleaimstolaunchlightonthelimitationsoftheCoaseandPigouapproachinthesolutionofexternalities.Aftercon...

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A solution for external costs beyond negotiation and taxation Alexandre Magno de Melo Fariaa Hélde A. D. Hdomb aFederal University of Mato Grosso F aculty of Economics. Brazil.

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