Seminar: "Stocks versus Flows: Second-Best Incentive Design for Stock-Generated Externalities" - Erica Chuang

Department of Agricultural, Food, and Resource Economics Seminar:

"Stocks versus Flows: Second-Best Incentive Design for Stock-Generated Externalities"

Erica Chuang
Ph.D.
Economic Fellow at the Institute for Policy Integrity

The growing electricity demand in the United States—driven by heating and transportation electrification as well as data center and Conventional wisdom states that incentives targeting stocks and flows can lead to equivalent externalities correction. However, this may not hold when externalities are more directly produced from stocks (“stock-generated externalities”) rather than flows of production, as is commonly modeled. Stocks that exhibit these external effects include trees and CO_2 absorption, shellfish and water cleaning, and livestock and methane emissions. I present a dynamic optimization model of privately-owned renewable resource extraction where the stock of natural capital jointly produces a private good and social benefits in order to assess the performance of various incentive-based policies. In particular, I explore how incentives targeting measures of stock abundance and flows of production perform relative to the social optimum and a no-policy benchmark. I present both theoretical and numerical results by calibrating the model to industry and scientific parameters from the Chesapeake Bay, where Eastern oyster (C. virginica) cultivation yields water filtration benefits. I find that stock-targeted incentives have the potential to achieve the socially optimal paths of resource abundance and environmental quality. While flow-targeting may achieve short run gains in environmental quality, as the system achieves a steady state the firm reverts back to levels of extraction as if no policy occurred. This is likely driven by differences in revenue sources for the firm. Stock-targeting allows the firm to flexibly maximize profits over two sources of revenue: the natural resource stock and the private good. By contrast, flow-targeting solely changes the price of the private good, leading to similar dynamics and the same profit maximization and extraction behavior as no-policy in steady state. The model provides a theoretical framework for incentive design aimed at minimizing environmental damages through management of privately-owned living natural resources.