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Wednesday, September 29, 2010

Oil Spills & Market Failure

You might think that because pollution is the classic example of an externality that the recent oil spill from the BP drilling facility was a negative externality. However, I find that there are 2 fundamental reasons to conclude that the BP oil spill was not a source of market failure.

First, recall that in class we discussed a silly illustration of an accident caused by me driving too fast. While that illustration involved harm only to me, I finished the illustration by saying that accidents were not externalities, and of course many accidents involve harm to people who were not responsible for causing the accident. Why shouldn't we think of the harm to others resulting from an accident as a negative externality? In general, a negative externality market failure is associated with circumstances for which liability and property rights are not well defined. When property rights (and therefore liability) is well defined, the cost of an accident will be internalized rather than externalized. After all, if I do something stupid which results in an auto accident that harms myself as well as the driver of another vehicle, I will be well aware of who must pay for the damage and harm caused. Specifically, I will bear the cost of the harm the accident caused to me, and when liability is well defined it is also clear that I will have to compensate for the harm my accident caused to others.

I think the BP oil spill fits this case pretty well. However, the ways in which it doesn't fit this will explain the second fundamental reason the BP oil spill is not a market failure. BP owns the rig and the facilities involved in drilling down to the ocean floor to poke a hole through which oil would flow out and be captured for productive uses. Clearly when the rig blew BP internalized the cost to itself in the lost facilities. In addition, the employees killed by the accident imply a damage or cost that BP must compensate for, just as any one would be required to compensate when the accident they caused killed another. In addition, if it is the case that the law clearly states that BP will be liable for any damage caused by oil released into the ocean, then BP would also have internalized this cost to others in the production decisions it made. But, on this point we move to my second reason why the BP accident was not an externality source of market failure.

I think it is useful to explain this second reason by first asking a few questions:
Who owned the ocean the oil was spilled into?
Who owned the oil under the ocean that BP was "harvesting?"
Who owned the ocean water that BP was going through with it's drilling piping, etc.?
Who owned the ocean floor that BP was poking the hole into?
The first answer to each of these questions is that BP owned none of these things. If there was an owner, it would be the decision maker that leased the "drilling rights" to BP. Who leased the drilling rights to BP? The U.S. Government did. Essentially the U.S. Government owns the oil under the ocean in this location, and it owns the earth and water in this location, and it even essentially owns the ocean into which the oil was spilled. The U.S. Government decided to lease the production rights to it's oil to BP, and this lease came with clearly defined terms and conditions by which BP could harvest the oil under the ocean in that location.

Because the U.S. Government made a contractual arrangement with BP for this lease, I presume the U.S. Government internalized both the benefit of the lease as well as the cost of a potential accident when it agreed to the lease itself. Furthermore, the U.S. Government said to BP that as part of the terms of the lease BP would have to submit to an entire set of regulations and permits coming from various agencies of the U.S. Government. You see the U.S. Government wanted to try to make sure the odds of an accident would be very low by controlling what BP could and couldn't do in terms of many of its production decisions. For example, there are reports that in the last day or two prior to the accident BP asked for at least 3 permit changes, each of which was granted by the appropriate government agency in less than 24 hours of review. It is even the case that Congress and the President created a statute a few years ago to try to encourage very deep drilling in the gulf, and it did this by limiting the potential liability any business such as BP would face should an accident occur. The terms of the liability limit was, essentially, that as long as BP was responsible in following the permits and other regulations the U.S. Government specified for its operations, and as long as BP was not willfully negligent, then there would be limited liability. And, when the Congress and the President created this statute it also created a tax on all U.S. oil production businesses and the revenue from this tax was to be used to create a fund that would be used in cleaning up after an oil spill as well as compensate for harm done beyond the liability limits to the producers themselves.

In summary, then, accidents are not externalities or sources of market failure as long as liability and property rights are well defined. Accidents are accidents and they are not really directly relevant to concerns with respect to the efficient allocation of resources. And, in the specific case of the BP spill, the typical market incentives that would be present to take sufficient precaution against an accident were missing because the exchange in question involved government and a private business, and further because the terms of the lease involved government statutes and regulations to control production as well as to limit liability for damages due to an accident. If you see the accident as an issue of efficiency, then I think you would have to say that the BP accident was not really a market failure, but instead a government failure.

Please add any questions or comments you might have.

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