Pigou (1920) pointed to "uncompensated damage done to surrounding woods by sparks from railway engines" as the canonical example of an environmental externality. We study a modern corollary - tropical forest fires used for land clearing - using 15 years of daily satellite data on fire hotspots across Indonesia. We examine how externalities affect the decision to use fire using the fact that fires are predictably more likely to spread on windy days, but the degree to which this is an externality depends on who owns surrounding land. We find firms overuse fire relative to a case where all spread risks were internalized. However, firms are partially sensitive to the risks of government punishment, which deters them from burning near protected forest or populated areas on particularly windy days. Counterfactuals suggest that if firms treated all surrounding land the way they treat land near populated areas, fires would be reduced by 80 percent.
This working paper is published under the Economics of Environment and Energy programme