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Externalities and Property Rights
Chapter 10
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
10-2
Learning Objectives1. Define negative and positive externalities and
analyze their effect on resource allocations2. Discuss and explain the Coase Theorem3. Explain how the effects of externalities can be
remedied and discuss why the optimal amount of an externality is almost never zero
4. Illustrate the tragedy of the commons and show how private ownership is a way of preventing it
5. Define positional externalities and their effects, and show how they can be remedied
10-3
External Costs and Benefits• An external cost is a cost of an activity that falls
on people other than those who pursue the activity– Also called a negative externality
• An externality is the name given to an external cost or external benefit of an activity
• An external benefit is a benefit of an activity received by people other than those who pursue the activity– Also called a positive externality
10-4
Externalities Affect Resource Allocation
• Externalities reduce economic efficiency– Solutions to externalities may be efficient– When efficient solutions to externalities are not
possible, government intervention or other collective action may be used
10-5
Honeybee Keeper – Scenario 1• Phoebe harvests and sells honey from her bees
– Bees pollinate the apple orchards • No payments made to Phoebe
• The bees provide a free service to the local farmers– Phoebe is giving away a service
• Private costs are equal to private benefits– Social costs are less than social benefits
When external benefits exist, maximizing private profits produces less
than the social optimum
10-6
Honeybee Keeper – Scenario 2• Phoebe harvests and sells honey from her bees• People at a neighboring school and nursing
home are bothered by bee stings• The bees are a nuisance to the neighbors
– Phoebe is not paying all the costs of her honeybees• Private costs are equal to private benefits
– Social costs are greater than social benefits
When external costs exist, maximizing private profits produces more
than the social optimum
10-7
External Cost
Quantity (tons/year)12,000
1.3
Pric
e ($
000s
/ to
n)
D
Private MC
$1,000/ton
External CostsP
rice
($00
0s /
ton)
No External Cost
Quantity (tons/year)12,000
1.3
D
Private MC
PrivateEquilibrium
Deadweight loss from pollution = $2 M/yr
SocialOptimum
2.3
Social MC
2.0
8,000
10-8
Positive Externality for Consumers
Deadweight loss frompositive externality
XB
MBPVT + XB
Social Demand
MBSOC
QSOC
Pric
e
Quantity
Private Demand
MC
QPVT
MBPVT
PrivateEquilibrium
SocialOptimum
10-9
Effects of Externalities
With externalities, private market outcomes
do not achieve the largest possible economic surplus
Cash is left on the table
10-10
Remedying Externalities• With externalities, private market outcomes do
not achieve the largest possible economic surplus– Cash is left on the table
• For example, with monopolies, output is lower than with prefect competition– Introduction of coupons and rebates expands the
market• With externalities, actions to capture the surplus
are likely
10-11
Abercrombie the Polluter –Scenario 1
• Abercrombie’s company dumps toxic waste in the river– Fitch cannot fish the river– No one else is harmed
• Abercrombie could install a filter to remove the harm to Fitch– Filter imposes costs on Abercrombie– Filter benefits Fitch
• Parties do not communicate
10-12
Abercrombie's Filter Options
With Filter Without Filter
Abercrombie's Gains $100 / day $130 / day
Fitch's Gains $100 / day $50 / day
Total Gains $200 / day $180 / day
Abercrombie does not install the filter Marginal cost of filter to Abercrombie is $30 per day The marginal benefit to Fitch is $50 per day
There is a net welfare loss of $20 per day
10-13
Abercrombie the Polluter –Scenario 2
• Communication changes the outcome– Fitch pays Abercrombie between $30 and $50 per
day to use the filter– Net gain in total surplus of $20 per day
With Filter Without Filter
Abercrombie's Gains $100 / day $130 / day
Fitch's Gains $100 / day $50 / day
Total Gains $200 / day $180 / day
10-14
The Coase Theorem• The Coase Theorem says that if people can
negotiate the right to perform activities that cause externalities, they can always arrive at efficient solutions to problems caused by externalities– Negotiations must be costless
• Sometimes those harmed pay to stop pollution– Fitch pays Abercrombie
• Sometimes polluter buys the right to pollute– Abercrombie pays Fitch
• The adjustment to the externality is usually done by the party with the lowest cost
10-15
Abercrombie the Polluter –Scenario 3
• Abercrombie’s company produces toxic waste– Laws prohibit dumping the waste in the river
UNLESS Fitch agrees– New gains matrix
With Filter Without Filter
Abercrombie's Gains $100 / day $150 / day
Fitch's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
10-16
Abercrombie the Polluter –Scenario 3
• Abercrombie can pay Fitch up to $50 per day for the right to pollute– Fitch will accept any offer over $30 per day
• In this scenario, polluting is the right thing to do
With Filter Without Filter
Abercrombie's Gains $100 / day $150 / day
Fitch's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
10-17
Laws Can Change the Outcome• Suppose the law makes polluters liable for the
cost of cleaning up their pollution– Polluters get lower incomes– Non-polluters get higher incomes
With Filter Without Filter
Abercrombie's Gains $100 / day $150 / day
Fitch's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
10-18
Shared Living• Ann and Betty are evaluating housing options
– 2-bedroom apartment for $600 per month OR– 2 1-bedroom apartments for $400 per month each
• If the costs were the same, Ann and Betty would be indifferent between the two arrangements
• The externality here is Ann's telephone usage is high– She would pay up to $250 per month to be able to
use the phone whenever she wants– Betty would pay up to $150 per month to get better
phone access– No second phone line is possible
10-19
Benefits and Costs of Shared Living
$800 per month $600 per month $200 per monthTotal Cost of Separate
ApartmentsTotal Cost of
Shared ApartmentRent Savings from Sharing
Live together if the benefits exceed the costs
ProblemAnn's Cost of Solving the
Problem
Betty's Cost of Solving the
Problem
Least-Cost Solution
Ann's phone usage
Pay Ann $250 to decrease usage
Pay Betty $150 to tolerate Ann
Ann pays Betty $150 per
month
10-20
Net Benefit of Shared Living
• Ann and Betty will live together
$200 per month $150 per month $50 per month
Rent Savings Cost of Phone Accommodation Gain in Surplus
10-21
Dividing the Rent• Betty would spend $400 per month to live alone
– The cost of tolerating Ann's phone use is $150 per month
– Betty will be willing to pay up to $250 = $400 - $150 to live with Ann• Above $250, she will be better off living alone
• Ann is willing to pay up to $400 per month, the cost of living alone
10-22
Dividing the Surplus• Betty's maximum rent is $250• Ann's maximum rent is $400• If they divide the surplus ($50) equally,
– Betty pays $225 = $250 – $25– Ann pays $375 = $400 – 25
10-23
Legal Remedies for Externalities
• If negotiation is costless, the party with the lowest cost usually makes the adjustment– Private solution is generally adequate
• When negotiation is not costless laws may be used to correct for externalities– The burden of the law can be placed on those who
have the lowest cost
10-24
Examples of Legal Remedies for Externalities
• Noise regulations (cars, parties, honking horns)• Most traffic and traffic-related laws
– Car emission standards and inspections• Zoning laws• Building height and footprint regulations
(sunshine laws)• Air and water pollution laws
10-25
Three CasesFree Speech
• First Amendment recognizes the value of open communications
• Hard to identify speech that has a net cost
• Some limitations• Yelling "fire" in a
crowded theatre• Promote the violent
overthrow of the government
• Pornography
Planting Trees• Government subsidizes
trees on private property• Decreases chances of
flooding and landslides• Net reduction of CO2 in
the atmosphere
Basic Research• Millions of dollars spent
by federal government yearly
• Externalities of new knowledge
10-26
Optimal Amount of Negative Externalities
Quantity of Pollution
MC & MBMC
Q
MC = MB
MB
Optimal amount of pollution
10-27
Taxes and Subsidies• When transaction costs prohibit negotiation:
– Negative externalities result in overproduction– Positive externalities result in underproduction
• A per unit tax on output can move the market to the socially optimal output when there is a negative externality
• A per unit subsidy on output can move the market to the socially optimal output when there is a positive externality
10-28
Quantity (tons/year)P
rice
($00
0s /
ton)
D
Private MC
12,000
1.3
Pollution Tax$1,000 / ton
Taxing a Negative Externality
Tax
Private MC + Tax
2.32.0
8,000
2.0
8,000
Quantity (tons/year)
Pric
e ($
000s
/ to
n)
D
Private MC1.3
12,000
No Pollution Tax
Private Equilibrium
Social Optimum
After Tax Equilibrium
Before Tax Equilibrium
Social MC
XC
10-29
Subsidizing a Positive Externality
12
Quantity (000s tons/year)
Pric
e ($
/ to
n)
Private Demand
MC
8
No Subsidy
XB
Social Demand
14
10
16
Quantity (000s tons/year)
Pric
e ($
/ to
n)
Subsidy
Private Demand
MC
Subsidized Demand
Subsidy
12
8
14
10
16
10-30
Tragedy of Commons• When use of a communally owned resource has
no price, the costs of using it are not considered– Use of the property will increase until MB = 0– This is known as the tragedy of the commons
• Suppose 5 villagers own land suitable for grazing– Each can spend $100 for either a steer or a
government bond that pays 13%– Villagers know what everyone before them has done– Steer graze on the commons– Value of the steer in year 2 depends on herd size
10-31
Payoff For a Steer• Using the information in the table below, each
villager makes a decision
• The fourth is indifferent between the two assets– He buys a steer
• The fifth buys a bond
# Steers Selling Price per Steer Income per Steer1 126 262 119 193 116 164 113 135 111 11
10-32
What the Villagers Did• The village has 4 steer feeding on the commons
for one year– At the end of the year, 4 steer sell for $113 each
• Total revenue for the village is (5) (113) = $565– Outcome is the same as 5 bonds
• They could have done better
10-33
A Better Choice
# Steer Selling Price
Income per steer
Total Cattle Income
Marginal Income
1 126 26 26 262 119 19 38 123 116 16 48 10
Net income from one bond after one year is $13 Buy a steer only if its marginal benefit is at least $13
First villager buys a steer and all others buy bonds Total net income is 26 + (4) (13) = $78 A net gain of $13 compared to the first scenario
Tragedy of the commons is the tendency for a resource that has no price to be used until its marginal benefit is zero
10-34
The Effect of Private Ownership• The villagers decide to auction off the rights to
the commons – Auction makes the highest bidder consider the
opportunity cost of grazing additional steer– Villagers can borrow and lend at 13%.– One steer is the optimal number
• Winning bidder pays $100 for the right to use the commons
10-35
The Effect of Private Ownership• The winning bidder starts the year
– Spends $100 in savings to buy a yearling steer– Borrows $100 at 13% to get control of commons
• The winning bidder ends the year– Sells the steer for $126
• Gets original $100 back• $13 opportunity cost of buying a steer• $13 interest on loan for the commons
• Economic surplus of the village is(4 x $13) + $26 = $78
10-36
Property Rights and the Tragedy of Commons
Blackberries in the Park• Sweetness increases as the
berry ripens• Blackberries are common
property– Berries will be eaten
before they are fully ripe
Other Examples• Harvesting
– Timber on remote public land
– Whales in open oceans• Worldwide pollution controls
Shared Milkshakes• Milkshakes chill taste buds
– Decrease appreciation of its flavor
– Drinking slowly increases appreciation
• If two people share the milkshake, it is a common good– They will drink faster than if
it were a private good
10-37
Positional Externalities• Highest compensation goes to the best performer
– Standard is relative, not absolute• Each player increases spending to increase
probability of winning– Sum of all these investments > collective payoff
• Total payout is fixed, so players' group has no gains
10-38
Football Players Take Steroids• Smith and Jones compete for one $1 million contract
– Each has 50% chance at the contract• Smith and Jones have a Prisoner's Dilemma
Jones's OptionsSmith's Options No Steroids Steroids
No Steroids 2nd best for eachWorst for Smith
Best for Jones
SteroidsBest for Smith
Worst for Jones3rd best for each
10-39
Positional Externalities• Relative performance determines reward
– Positional externalities occur when an increase in one person's performance reduces the expected reward of another
• A positional arms race is a series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality– A positional arms control agreement attempts to
limit the mutually offsetting investments in performance enhancements by contestants
10-40
Examples of Positional Arms Control Agreements
• Campaign spending limits• Roster limits• Arbitration agreements• Mandatory starting dates for kindergarten• Social Norms as Positional Arms Control
Agreements– Nerd norms– Fashion norms– Norms of taste– Norms against vanity
10-41
Externalities and Property RightsExternalities and Property Rights
Remedies
Coase Theorem
Laws
Taxes & Subsidies
Tragedy of the Commons
Positional Externalities
Effects of External
Costs
Effects of ExternalBenefits
Recommended