The commons, property rights and externalities

Two properties sort goods. A good is rival if one person’s use leaves less for others, and excludable if people who do not pay can be kept from using it. Combining them gives four kinds (CUET 2023, 2026):

Public goods are under-supplied by markets because each person can free-ride: with no way to exclude them, nobody has a reason to pay, and each consumer will not bid for the good (UGC NET 2023). Samuelson (1954) showed that the efficient amount of a public good is found by adding the individual marginal benefits vertically at each quantity, since all consume the same amount, and not horizontally as for a private good. Lindahl’s theory gives a way of pricing public goods in proportion to each person’s benefit; Buchanan’s club theory deals with their production and the size of the group that shares them; Parkinson’s law concerns the growth of government employment, and Hotelling’s rule the pricing of exhaustible resources (UGC NET 2024). Mixed cases between purely private and purely social goods generate external benefits or costs. A greenhouse gas is a “bad” that is non-rival and non-excludable (GATE 2023), which is why the climate is the standard global externality.

Markets fail in the presence of market power, positive and negative externalities and asymmetric information (CUET 2023); this lesson takes the externality and public-good cases.

Garrett Hardin (1968) asked the reader to picture a pasture open to all. Each herder asks what adding one more animal is worth. The herder receives all of the gain from the animal, and bears only a share of the cost, the slightly poorer grazing for every animal on the pasture. The sum is positive for each herder, so each adds an animal, and so does every other; “ruin is the destination toward which all men rush”. Hardin’s remedy was “mutual coercion, mutually agreed upon”. H. Scott Gordon (1954) had made the same point for fisheries, and Steven Cheung (1970) for non-exclusive resources generally.

Here is the arithmetic. Let each animal yield 100 − N, where N is the number on the pasture, and cost c to keep. A sole owner counts the damage each extra animal does to the others, and keeps animals until the extra yield of one more equals its cost: N = (100 − c)/2. With n herders, each takes the others’ animals as given and ignores the damage to them, so each adds animals until the average yield equals the cost, and the herd settles at N = (100 − c)·n/(n + 1). As n grows this approaches the open-access limit N = 100 − c, where the value left after costs is zero: all the rent of the pasture is dissipated. With the cost of keeping an animal at 20, a sole owner keeps 40 animals and the pasture yields a value of 1,600 after costs; two herders keep 53 and capture 89 per cent of that value; five keep 67 and capture 56 per cent; twenty keep 76 and capture 18 per cent; and with open access the pasture holds 80 and yields nothing. The structure is that of a Cournot oligopoly, where each firm ignores the effect of its output on the price received by others.

Elinor Ostrom (Governing the Commons, 1990) collected cases in which people had managed common-pool resources for generations, among them Swiss alpine meadows, Japanese mountain commons, inshore fisheries in Turkey and irrigation systems in Spain and the Philippines, and compared them with cases of collapse. She found neither of the two remedies usually proposed, privatisation or state control, to be necessary: the successful cases were run by the users themselves. She shared the Nobel Memorial Prize in Economic Sciences in 2009 (UOH 2010 asks for the winner of the work on “Governing the Commons”), and UGC NET 2025 asks what a common-pool resource needs in order to survive: a credible commitment of the collective that lives on it.

The eight design principles she drew from the long-lasting cases:

1. Clearly defined boundaries: who may use the resource, and what the resource is.
2. Rules on use and on provision that fit local conditions.
3. Collective-choice arrangements: those affected can take part in changing the rules.
4. Monitoring of users and of the state of the resource, by the users or by those answerable to them.
5. Graduated sanctions for those who break the rules.
6. Cheap and quick ways to settle conflicts.
7. Minimal recognition by outside authorities of the users’ right to organise.
8. For larger systems, nested layers of organisation.

Where the principles fail, for example where the group is large, outsiders cannot be excluded or the state overrides local rules, the result can be the tragedy Hardin described. Baland and Platteau (1996) surveyed the evidence, including for India, and found that community management works under conditions that are not always present. The analytical point is that open access and common property are different: Hardin’s argument holds for the first. Kenneth Boulding (1966) put the same concern at the scale of the planet in “The economics of the coming spaceship Earth”.

A. C. Pigou (The Economics of Welfare, 1920) argued that where a firm’s activity imposes a cost on others, the state should tax the activity by the amount of the damage, so that the firm faces the full social cost. A Pigouvian tax moves production to the socially optimal level (UOH 2013). The steps in order are: identify the external cost, measure the marginal external damage, add it to the private cost to get the marginal social cost, set the tax equal to the marginal damage at the efficient output, and check that welfare rises (CUET 2026). A pollution tax was suggested by Pigou (UGC NET 2024).

An example. A paper mill has total benefit 120Q − Q² and total cost 20Q, and its effluent causes damage Q² (JAM 2021). Left alone, the mill sets the marginal benefit 120 − 2Q equal to its marginal cost 20 and produces Q = 50. The marginal damage is 2Q. The social optimum sets 120 − 2Q = 20 + 2Q, which gives Q = 25. At Q = 25 the marginal damage is 50, so the tax is 50 per unit: it raises the mill’s marginal cost to 70, and the mill then chooses 120 − 2Q = 70, that is Q = 25.

A subsidy to abatement can get each existing firm to cut pollution by the efficient amount, but it is not an effective instrument in the long run in a competitive market: it lowers firms’ costs, so it draws in more firms, and the industry’s output can end up above the socially desired level (UGC NET 2023; Baumol and Oates, 1988). A tax has the opposite effect on entry.

Ronald Coase (“The problem of social cost”, 1960) argued that the externality is a problem of reciprocal harm, since the factory harms the neighbour only because the neighbour is there, and that if the right to pollute or to be free of pollution is clearly assigned and bargaining is costless, the two parties will reach the efficient outcome by themselves. George Stigler later called this the Coase theorem (UOH 2010, 2016). It concerns externalities and rests on assumptions: absence of transaction costs, complete property rights, complete information and no income (wealth) effect (UGC NET 2024, 2026).

An example. A factory earns 100 if it pollutes and 50 if it installs a filter (so the filter costs it 50). The pollution costs a neighbouring farm 80. Filtering is efficient, because the damage avoided, 80, is more than the cost, 50. Suppose the factory has the right to pollute: the farm will pay up to 80 to have it filter, the factory will accept anything above 50, and a payment between 50 and 80 leaves both better off. Suppose instead the farm has the right to clean air: the factory must either filter at a cost of 50 or compensate the farm 80, so it filters. Either way the factory filters. What changes is who pays: in the first case the farm pays, in the second the factory does. So the polluter-pays and victim-pays rules differ in distribution and not in efficiency (UGC NET 2025: possible outcomes of assigning property rights include the polluter paying the victim to continue polluting, the victim paying the polluter to reduce pollution, and efficiency achieved by the market).

When the assumptions fail, so does the argument: with many polluters and many victims, bargaining costs are high, and rights can be hard to define for air, rivers or the climate. That is why the government steps in with taxes, standards and permits.

Environmental policy uses three kinds of instrument. Command and control regulates polluters directly through standards (UGC NET 2023): a technology standard designates the equipment or method, a performance standard a limit to be met without stating how, and an ambient standard designates the quality level of some element of the environment to be achieved, such as the concentration of a pollutant in air or water. Market-based or incentive instruments, taxes and subsidies, encourage conservation or pollution-reducing technology. A tradable permit system sets the total quantity of pollution and creates a market in rights to pollute. Cost-effectiveness means reaching a given objective with the least amount of resources.

Why permits are cost-effective: suppose two firms must together cut pollution by 30 units. Firm 1’s marginal cost of abatement is 2e₁ and firm 2’s is e₂. With a uniform standard each cuts 15 and total cost is 15² + 15²/2 = 337.5. With tradable permits the firms trade until marginal costs are equal, 2e₁ = e₂, which with e₁ + e₂ = 30 gives e₁ = 10 and e₂ = 20, at a permit price of 20 and a total cost of 100 + 200 = 300: a saving of 37.5 for the same total reduction. J. H. Dales (1968) proposed the idea of marketable pollution rights. The choice between a tax and a quantity limit when the cost of abatement is uncertain was analysed by Weitzman (1974). Climate policy, with a carbon tax or a cap-and-trade scheme, is the subject of Lesson 16.

The Delhi School entrance asks for the competitive output and the social optimum when production causes pollution, with a marginal pollution cost that rises with output. The method is the one above: competitive output where demand equals the private marginal cost, social optimum where demand equals the private marginal cost plus the marginal pollution cost.

Questions on kinds of goods, the commons, Coase, Pigou and environmental instruments. The four types of externality and their diagrams are on the externalities page; valuation, accounts and climate policy are in Lesson 16.