Let Tiebout pick up the tab: Pricing out externalities with free mobility

• Date: 01 March 2017
• DOI: http://doi.org/10.1111/ijet.12121
• Published date: 01 March 2017
• Author: Hiroki Watanabe

doi: 10.1111/ijet.12121

Let Tiebout pick up the tab: Pricing out externalities

with free mobility

Hiroki Watanabe∗

Free mobility has not been thought of as an effective tool to correct over- or underproduction

of externalities. In this paper, we establish that foot voting can internalize the cost of negative

externalities. Workers have to accept the wage and rent, however high or low these values are

in equilibrium, if they cannot relocate. In reality, workers are mobile and they can effectively

influence the equilibrium wage and rent to reflect the externalities by threatening to walk away

if the current externalities are at an intolerable level. In an economy with free mobility, firms

indirectly pay for the damage in the form of an increased labor or land cost and thus the

externalities are partially internalized. Wespecify the condition under which a mobile economy

is efficient in the presence of externalities, and discuss potential policy implications of our

findings.

Key wor ds externality, foot voting, quality of life, production economy

JEL classification D62, R23, R13

Accepted 25 March2016

1 Introduction

Externalities are stressful to deal with. Decentralized decision-making does not get us to an efficient

allocation. Externalities, by definition, are not priced to reflect beneficial or adverse effects imposed

on a third party. Competitive equilibrium assigns zero to the shadow price of the third party’s

objective function and/or constraint when these should not be slack. There havebeen many attempts

to assign the right multiplier to the third party. Duranton and Puga (2004) list four equilibrium

concepts used in an urban economic context: competitive,free mobility, Nash and core. Just because

the competitive equilibrium fails to deliver efficiency does not mean that the other three fail as well.

Wewill show that under some conditions, the introduction of free mobility can Pareto improve upon

the competitive equilibrium when externalities are present.

In Roback (1982), the firms take the amenity level as given. Here, we will let the firms pick

their own industrial emission levels, which correspond to the amenity level in Roback (1982). It

is at their discretion to adopt pollution abatement measures and decide how much reduction in

pollution is optimal. The trade-off that the firms face is as follows: while abatement technology is

costly to implement, the improved living environmentrealized through reduced industrial emissions

will lower the wage and thus the firms can recoup the emission-related cost increase from reduced

∗Department of Economics and Finance, Lamar University,Beaumont, TX, USA. Email: watanabe.wustl@gmail.com

I am indebted to Marcus Berliant, Karyn Neuhauser, and an anonymous referee for very valuable suggestions. All the

remaining errors are mine.

International Journal of Economic Theory 13 (2017) 147–162 © IAET 147

International Journal of Economic Theory

Let Tiebout pick up the tab Hiroki Watanabe

labor cost. The firms decide how far they can go with their emissions before the air pollution starts

to eat into their profit through increased labor cost.

Variousalternatives or fixes to competitive equilibrium have been suggested, among them Pigou-

vian tax, tradable permits, bargaining (Coase 1960), or command and control. Wepropose another

alternative that we have already set in place without realizing it. The fixes listed above do not have

a geographical dimension. For example, Baumol (1972) mentions the relocation of the laundry in-

dustry to get away from smoke, and Pigouvian tax is proposed to control the migration dynamics of

the industry. The place that the laundry industry relocates to is presumably still within the same city

as there is only one location in the model. The effects of smoky air on the quality of life, and conse-

quently on the labor cost, are not considered. Residents cannot move out of their current location

regardless of the level of externalities because there are no other locations available.

The international trade literature does treat pollution in a geographical setting. Merrifield (1988)

discusses pollution abatement technologies in the international context. While pollutants and goods

are internationally mobile, workers are not. The equilibrium utility level will not equalize across

the border, and thus wages or rents do not work as a compensatory mechanism for differing living

environments by location as established by Roback (1982). Pethig (1976) discusses the location of

production as a result of welfare differentials but not the location of consumers. In fact, utility

maximization is absent in Merrifield (1988), as transborder pollution is received by the producers

in the form of reduced productivity. Forster (1981) talks about labor mobility but it pertains to

industries, not locations. By and large, workers are not mobile in the international trade literature.

In reality, we usually have competitive outside options as individuals. If externalities are over-

or underproduced to our liking, we can always pack up and leave to find another city that offers

a more desirable allocation. While some externalities spread uniformly across the country, most of

them are either fully contained within a limited area or decay rapidly with distance.1Unlike these

location-bound externalities, consumers are not inexorably tied to a particular city. The footloose

nature of consumers has been overlooked but deserves some attentionbecause it does exist in reality.

Tiebout (1956) was the first to recognize that unconstrained residential choice of jurisdictions

emulates the competitive equilibrium for local public goods under certain tax schemes. We will

expand on this idea to see if and when foot voting works to manage externalities, which is a gener-

alization of local public goods. Our departure from Tiebout’s work is that there is no public sector

and externalities are created as a result of firms’ profit maximization. We do not assign a non-zero

shadow price on the injured party (in our case, consumers) per se, but rather, we will have firms

realize it through the market equilibrium with free mobility. They are still welcome to ignore the

damage they inflict upon the consumers, but doing so will be costly because that can come with a

higher equilibrium wage and/or rent and their profitability may suffer.Thus, we can use free mobility

to price out at least some externalities, or, to put it in another way, let Tiebout take care of the bill

for the shadow price.

In fact, compensation through the equilibrium rent or wage is not a brand-new idea. In the

quality of life literature, it is known that residents in a subpar city in terms of living environment are

compensated for the quality of life with a lower equilibrium rent and/or a higher equilibrium wage.

In this light, we will base our model on Roback (1982) and integrate Tiebout’s idea intoit.

As such, there are two lines of research related to our work. One is on the quality of life and

the other is public finance. The literature on the quality of life assumes that the amenity level is

1This is the premise of aforementioned Baumol (1972), wherethe laundr y industry can avoid the effects of the externalities

by relocation.

148 International Journal of Economic Theory 13 (2017) 147–162 © IAET