14-1

Economics: Theory Through Applications

14-2

This work is licensed under theCreative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License.To view a copy of this license,visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter toCreative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105,

USA

14-3

Chapter 14Cleaning Up the Air and Using Up the Oil

14-4

Learning Objectives

• What is the Coase theorem?

• Why is the Coase theorem important?

• What is a social dilemma?

• What is an externality?

• What are the ways in which problems caused by externalities can be solved?

Learning Objectives

• What are some of the difficulties in designing policies to deal with externalities?

• What is the Hotelling rule for the use of resources?

• What is a non-excludable good?

• What is an accumulable resource?

14-5

Figure 14.1 - The 30 Most Polluted Cities in the World

14-6

Figure 14.2 - The Gains from Trade

14-7

Mixed Messages

14-8

Table 14.1 - The Payoffs in a Social Dilemma Game

14-9

Figure 14.3 - A Divergence between Marginal Private Cost and Marginal Social Cost

14-10

Figure 14.4 - A Divergence between Marginal Private Benefit and Marginal Social Benefit

14-11

The Hotelling Rule

14-12

Price next yearNominal interest factor

Price this year

Figure 14.5 - The Price of Oil (in 2008 Dollars)

14-13

Key Terms

• Buyer’s surplus: A measure of how much the buyer gains from a transaction that is equal to the buyer’s valuation minus the price

• Seller’s surplus: A measure of how much the seller gains from a transaction that is equal to the price minus the seller’s valuation

• Property rights: An individual’s (or institution’s) legal right to make all decisions regarding the use of a particular resource

• Transaction costs: The costs of making and enforcing agreements

14-14

Key Terms

• Coase theorem: If property rights are clearly established and transaction costs are low, private bargaining will lead to efficient outcomes

• Social dilemma: A situation where individually rational choices lead to an outcome that is bad for society as a whole

• Marginal valuation: The maximum amount an individual would be willing to pay to obtain one extra unit of that good

• Marginal cost: The extra cost of producing an additional unit of output, which is equal to the change in cost divided by the change in quantity

14-15

Key Terms

• Marginal social cost: The cost to society of consuming or producing one more unit of a good or a service

• Externality: The direct cost imposed or direct benefit bestowed by one person’s actions on others in society

• Negative externality: The direct cost imposed by one person’s actions on others in society

• Positive externality: The direct benefit bestowed by one person’s actions on others in society

14-16

Key Terms

• Marginal social benefit: The benefit to society of consuming or producing one more unit of a good or service

• Tradable emission permit: A license to emit a specified amount of pollution

• Command and control: Regulation in which there are mandates for maximum permissible levels of pollution

• Contingent valuation: The techniques used for eliciting the values that individuals place on goods and services that are not bought and sold in the marketplace

14-17

Key Terms

• Risk averse: Being willing to pay more than a gamble’s expected loss in order to avoid that gamble

• Nonrenewable (exhaustible) resource: A resource that does not regenerate over time

• Hotelling rule: An arbitrage condition for the use of resource stocks

• Arbitrage: The act of buying and then selling an asset to make a profit

• Nominal interest factor: A factor, equal to 1 + nominal interest rate, used to convert dollars today into dollars next year

14-18

Key Terms

• Non-excludable: A good (or resource) for which it is impossible to selectively deny access

• Excludable: A good (or resource) that we can selectively allow or deny access

• Renewable resource: A resource that regenerates over time

• Accumulable resource: A resource that can be increased without limit over time through investment

• Human capital: The skills and knowledge that are embodied within workers

14-19

Key Takeaways

• The Coase theorem states that if property rights are well defined and transactions costs are low, then bargaining will lead to an efficient outcome

• The Coase theorem provides the rationale for a market solution to pollution and other similar social problems

• A social dilemma arises when there are many individuals each making choices that are in their self-interest but leading to an outcome that is bad for society

14-20

Key Takeaways

• An externality arises when an action taken by one person directly affects another’s welfare

– These operate outside of markets

• One solution to an externality problem is to create a market so that the affects of one person’s actions on others will be reflected in the market price of taking that action

– Another solution is to put in place taxes or subsidies so that private incentives are aligned with social goals

14-21

Key Takeaways

• One challenge for policy design is that the valuation of environmental goods is difficult to measure

– Moreover, external effects do not respect borders, so international agreements are often required

• According to the Hotelling rule, a resource should be extracted so that the rate of price increase in the resource should be the same as the interest rate

14-22

Key Takeaways

• A good is nonexcludable if it is impossible to deny access to it

• An accumulable resource is one that can be increased over time with investment

– Leading examples include physical capital and human capital

14-23