Lecture Principles of economics (Asia Global Edition) - Chapter 10

Chapter 9 - Externalities and Property. 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.

Externalities and Property

Rights Chapter 10

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

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

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

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

When external benefits exist, maximizing private profits produces less

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

When external costs exist, maximizing private profits produces more

than the social optimum

Social MC

2.0

8,000

Positive Externality for

MBSO

C

QSO C

MC

QP VT

MBP VT

Private Equilibrium

Social Optimum

Effects of Externalities

With externalities, private market outcomes

do not achieve the largest possible economic surplus

Cash is left on the table

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

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

Abercrombie's Filter Options

§ 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

Abercrombie the Polluter –

Scenario 2

– Fitch pays Abercrombie between $30 and $50 per

day to use the filter

– Net gain in total surplus of $20 per day

Abercrombie's Gains $100 / day $130 / day

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

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

Abercrombie's Gains $100 / day $150 / day

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

Abercrombie's Gains $100 / day $150 / day

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

Abercrombie's Gains $100 / day $150 / day

Shared Living

• Ann and Betty are evaluating housing options

– 2-bedroom apartment for $600 per month OR

– 21-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

Benefits and Costs of Shared

Living

Total Cost of Separate

Apartments Shared Apartment Total Cost of Rent Savings from Sharing

§ Live together if the benefits exceed the costs

Problem Ann'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

Net Benefit of Shared Living

• Ann and Betty will live together

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

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

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

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

– Car emission standards and inspections

Three Cases

Free Speech

• U.S First Amendment

recognizes the value of

open communications

that has a net cost

Planting Trees

• Government subsidizes trees on private property

flooding and landslides

in the atmosphere

Basic Research

• Millions of dollars spent

by central government yearly

Optimal Amount of Negative

of pollution

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

Quantity (tons/year)

12,000 1.3

Pollution Tax

$1,000 / ton

Taxing a Negative Externality

Tax Private MC + Tax

12,00 0

Subsidizing a Positive

Externality

12 Quantity

MC

Subsidized Demand Subsidy

12

8

14 10

16

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

Payoff For a Steer

• Using the information in the table below, each

villager makes a decision

• The fourth is indifferent between the two assets

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

Tragedy of the commons is the tendency for a resource that has

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

Property Rights and the Tragedy of

Commons

Blackberries in the Park

berry ripens

property

they are fully ripe

it were a private good

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

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

No Steroids 2nd best for each Worst for Smith

Best for Jones

Steroids Best for Smith

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

Examples of Positional Arms

Control Agreements

• Campaign spending limits

• Roster limits

• Arbitration agreements

• Mandatory starting dates for kindergarten

• Social Norms as Positional Arms Control

Externalities and Property Rights

Externalities and Property Rights

Effects of External Benefits