Lecture Principles of economics (Brief edition, 2e): Chapter 9 - Robert H. Frank, Ben S. Bernanke

Chapter 9 - Externalities and property rights. In chapter 9 we will investigate how the allocation of resources is affected when activities generate costs or benefits that accrue to people not directly involved in those activities. We will see that if parties cannot easily negotiate with one another, the selfserving actions of individuals will not lead to efficient outcomes

Chapter 9: Externalities and

Property Rights

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

4 Discuss why the optimal amount of an externality is

almost never zero

5 Illustrate the tragedy of the commons and show

how private ownership is a way of preventing it

6 Define positional externalities and their effects, and

show how they can be remedied

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

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

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

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

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

Examples of Legal Remedies for Externalities

• Noise regulations (cars, parties, honking horns)

• Most traffic and traffic-related laws

• Zoning laws

• Building height and footprint regulations (sunshine laws)

• Air and water pollution laws

Optimal Amount of Negative

Externalities

Quantity of Pollution

MC & MB

MC

Q

MC = MB

MB

Optimal amount

of pollution

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

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

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

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

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

Examples of Positional Arms

Control Agreements

• Campaign spending limits

• Roster limits

• Arbitration agreements

• Mandatory starting dates for kindergarten

• Nerd norms

• Fashion norms

• Norms of taste

• Norms against vanity

Externalities and Property Rights

Externalities and Property Rights

Remedies

Coase Theorem

Laws Taxes & Subsidies

Tragedy of

the Commons

Positional

Externalities

Effects of External Costs

Effects of External Benefits