Chap010 lecture

08/26/2013

1

Externalities and Property Rights

Chapter 10

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

10-2

Learning Objectives

1. Define negative and positive externalities and analyze their effect on resource allocations

2. Discuss and explain the Coase Theorem

3. 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

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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

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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

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10-7

External Cost

Quantity (tons/year)

12,000

1.3

Pric

e ($

000s

/ to

n)

D

Private MC

$1,000/ton

External Costs

Pric

e ($

000s

/ to

n)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

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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

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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

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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

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• 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





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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

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• Abercrombie’s company produces toxic waste– Laws prohibit dumping the waste in the river

UNLESS Fitch agrees

– New gains matrix





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• 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





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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





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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

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Benefits and Costs of Shared Living

$800 per month $600 per month $200 per month

Total Cost of Separate Apartments

Total Cost of Shared Apartment

Rent 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

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Net Benefit of Shared Living

• Ann and Betty will live together

$200 per month $150 per month $50 per month

Rent SavingsCost of Phone

AccommodationGain in Surplus

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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

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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

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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

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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

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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

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Optimal Amount of Negative Externalities

Quantity of Pollution

MC & MBMC

Q

MC = MB

MB

Optimal amount of pollution

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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

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Pric

e ($

000s

/ to

n)

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


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

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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

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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

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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 Steer

1 126 26

2 119 19

3 116 16

4 113 13

5 111 11

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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

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A Better Choice

# SteerSelling Price

Income per steer

Total Cattle Income

Marginal Income

1 126 26 26 26

2 119 19 38 12

3 116 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

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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

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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

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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

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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

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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 Options

Smith'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

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• 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

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Remedies

Coase Theorem

Laws

Taxes & Subsidies

Tragedy of the Commons


Effects of External

Costs

Effects of ExternalBenefits

Chap010 lecture

Education

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