I am teaching environmental economics this fall, and Tuesday was our first day of class. As I have structured the class, it focuses on common-pool resource allocation decisions. So I typically start the class with the example of a river, which I draw on the board. I ask students to name the different ways that we use the river (transportation, recreation, fishing, swimming, electricity, natural beauty, drinking water, dump waste from paper mill, irrigation, runoff from farms, etc.). As I start to populate the drawing with all of these uses, it quickly becomes apparent that some of these uses conflict — power generation and transportation, for example, or swimming and waste dumping.
So the problem is one of conflicting uses of a scarce resource. For most goods, market processes help us solve those problems, but with common pool resources we either have real limitations to the extent to which we can define property rights, or we have made political choices to manage the common pool resource as a public good.
Then today we did an in-class experiment called Paper River, in which the common pool resource is small sheets of paper. Half of the room made profits by producing math problems, solving them by writing in pencil on sheets of paper. The other half made profits by making paper airplanes, but here’s the catch: the paper has to be clean before the plane can be “sold”. So the downstream plane firms bore a cost due to the production processes of the upstream math firms.
After doing one round of this, we discussed some policy options that could help to incorporate this uncompensated external effect (I am eschewing the increasingly meaningless word “externality”). Here’s the list that they came up with:
- The plane firms should pay the math firms to use less paper
- The math firms should pay the plane firms for the cost of their having to erase
- The “government” (that would be me in this case) could subsidize clean paper or tax dirty paper
- The math firms could invest in calculators, eliminating their use of paper (i.e., change their production technology)
- The plane firms could adapt, and learn how to make planes with dirty paper (also a change in production technology, or maybe in customer acceptance)
- The “government” could impose a paper use quota on the math firms
Because of the way I set up the experiment, the paper of one math firm went to one plane firm, so what they did after generating this list was bilaterally meet and negotiate how they were going to deal with this situation. Although we haven’t explicitly talked about the Coase Theorem in class yet, this is clearly an exercise in defining property rights and negotiating.
Most of the groups, interestingly, had the plane firms paying the math firms to use less paper. One group reached this interesting agreement: the math firm gets one free piece of paper, but then has to compensate the paper firm 1/2 point per additional piece of paper used (the profits in this experiment are class participation points). Two sets of firms merged, illustrating the other Coase point that some transactions are less costly to consummate through firms than through markets!
Then they did a second round. The combined math firm + plane firm profits in Round 2 exceeded those from Round 1; their negotiations produced a Pareto improvement.
I really like starting the class this way, because we build a big, diverse menu of policy alternatives, and then we can start comparing, contrasting, analyzing, looking at pros and cons.
[cross-posted at Environmental Economics]