©2012 the mcgraw-hill companies, all rights reserved 1 chapter 10: externalities and property...
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©2012 The McGraw-Hill Companies, All Rights Reserved
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Chapter 10: Externalities and Property Rights
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Learning Objectives
1. Define negative and positive externalities and analyze their effect on resource allocations
2. Explain how the effects of externalities can be remedied
3. Compare and contrast the ways in which taxes and tradable permits can be used to reduce pollution
4. Discuss why the optimal amount of an externality is not zero
5. Characterize the tragedy of the commons and show how private ownership is a way of preventing it
6. Define positional externalities and their effects Show how they can be remedied
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External Costs and Benefits
External cost is a cost of an activity that is paid by people other than those who pursue the activity Also called a negative externality
External benefit is a benefit of an activity received by a third party
Also called a positive externality
Externality an external cost or benefit of an activity
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Externalities
This chapter focuses on how externalities affect the allocation of resources
Adam Smith’s theory of invisible hand applies to an ideal market, in which externalities do not exist In an ideal market, self-interested actions of
individuals would lead to socially efficient outcomes
In the case of externalities, when the parties affected can easily negotiate with one another, the invisible hand will still produce an efficient outcome
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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
Asal harvests and sells honey from her bees Her neighbors grow apples Bees pollinate their apple orchards
The bees provide a free service to the local farmers Asal is giving away a service
No payments made to Asal If Asal takes only her own costs and benefits into
account in deciding how many hives to keep, will she keep the socially optimal number of hives?
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Honeybee Keeper – Scenario 1
The bees provide a free service to the local farmers Since the orchard owners also benefit from
additional hives, the total benefit of adding another hive at that point will be greater than its cost
Private costs are equal to private benefits• Asal, then, will keep too few hives
Social costs are less than social benefits
When external benefits exist, maximizing private profits produces less
than the social optimum
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Honeybee Keeper – Scenario 2
Asal harvests and sells honey from her beesNeighboring school and nursing homes are
bothered by bee stingsThe bees are a nuisance to the neighbors
Asal 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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External Cost
Quantity (tons/year)
12,000
1.3
Pric
e ($
000s
/ t
on)
D
Private MC
$1,000/ton
How Do Externalities Affect Supply / Demand?
Pric
e ($
000s
/ t
on)
No External Cost
Quantity (tons/year)12,000
1.3
D
Private MC
PrivateEquilibrium
Deadweight loss from
pollution = $2 M/yr
SocialOptimu
m
2.3
Social MC
2.0
8,000
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How Do Externalities Affect Supply / Demand?
Since the external pollution cost falls not on firm owners but on others who live downwind from their factories,
Private MC is still the supply curve for this product, and its demand curve is again as before,
So the equilibrium price and quantity will be exactly the same as the one represented by the left graph
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How Do Externalities Affect Supply / Demand?
But this time the private market equilibrium is not socially optimal
As before, the market equilibrium level of output is 12,000 tons per year
However at that output level, the value to consumers of the last unit of output produced is only $1,300 per ton, while the true cost of producing that last unit (including the external cost) is $2,300 per ton
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How Do Externalities Affect Supply / Demand?
This means that society could gain additional economic surplus by producing fewer units of the product The same conclusion will continue to hold
whenever the current output exceeds 8,000 (where demand curve intersects Social MC)
As output expands past 8,000, the marginal cost of each successive unit (as measured on the Social MC curve) is greater than the marginal benefit of that unit (as measured on the demand curve) This entails a reduction in total economic
surplus Deadweight loss from pollution is $2 million
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Positive Externality for Consumers
Deadweight loss frompositive externality
XB
MBPVT + XB
Social Demand
MBSOC
QSOC
Pric
e
Quantity
Private Demand
MC
QPVT
MBPVT
PrivateEquilibrium
SocialOptimu
m
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How Do Externalities Affect Supply / Demand?
To summarize, Whether externalities are positive or
negative distort the allocation of resources in efficient markets
When externalities are present, the individual pursuit of self-interest will not result in the largest possible economic surplus
The outcome is thus inefficient
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Effects of Externalities
With externalities, private market outcomes
do not achieve the largest possible economic surplus
Cash is left on the table
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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 marketWith externalities, actions to
capture the surplus are likely
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The Coase Theorem
To say that a situation is inefficient means that it can be rearranged in a way that would make at least some people better off without harming others
The existence of inefficiency means that there is cash on the table, which usually triggers a race to see who can capture it For example, because monopoly pricing
results in an inefficiently low output level, the potential for gain gave monopolists an incentive to make discounts available to price-sensitive buyers
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Fawaz the Polluter – Scenario 1
Fawaz’s company dumps toxic waste in the river Fawzi cannot fish the river No one else is harmed
Fawaz could install a filter to remove the harm to Fawzi Filter imposes costs on Fawaz Filter benefits Fawzi
Parties do not communicate
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Fawaz’s Filter Options
With FilterWithout
Filter
Fawaz's Gains $100 / day $130 / day
Fawzi's Gains $100 / day $50 / day
Total Gains $200 / day $180 / day
Fawaz does not install the filter Marginal cost of filter to Fawaz is $30 per day The marginal benefit to Fawzi is $50 per day
There is a net welfare loss of $20 per day
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Fawaz the Polluter – Scenario 2
Communications (at no cost) changes the outcome Fawzi pays Fawaz between $30 and $50
per day to use the filter Net gain in total surplus of $20 per day
With FilterWithout
Filter
Fawaz’s Gains $100 / day $130 / day
Fawzi’s Gains $100 / day $50 / day
Total Gains $200 / day $180 / day
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The Coase Theorem
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• The case of Fawaz and Fawzi
Sometimes polluter buys the right to pollute• Fawaz pays Fawzi if the value of polluting is greater than
the harm to Fawzi
The adjustment to the externality is usually done by the party with the lowest cost
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The Coase Theorem
Coase theorem if at no cost people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities
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Fawaz the Polluter – Scenario 3
Fawaz’s company produces toxic waste Laws prohibit dumping the waste in the
river UNLESS Fawzi agrees New gains matrix
With FilterWithout
Filter
Fawaz's Gains $100 / day $150 / day
Fawzi's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
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Fawaz the Polluter – Scenario 3
Fawaz can pay Fawzi up to $50 per day for the right to pollute Fawzi will accept any offer over $30 per day
In this scenario, polluting is the right thing to do
With FilterWithout
Filter
Fawaz's Gains $100 / day $150 / day
Fawzi's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
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Price Incentives and the Environment
Goods with negative externalities tend to be overproduced
Social objective is to reduce pollution by half from its unregulated level The most efficient solution is one where
the marginal cost of pollution abatement is the same for all polluters
Cost data are not available to government One solution is to have all reduce
pollution by the same proportion Uneven distribution of costs
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Price Incentives and the Environment
One policy option is to tax pollution Businesses decide how much pollution to produce
2 firms, 5 production processes each Production differs by cost and amount of pollution
Process (smoke)
A (4
T/day)
B(3 T / day)
C(2
T/day)
D(1
T/day)
E(0
T/day)
Sludge Oil ($/day)
$100 $200 $600 $1,300 $2,300
NW Lumber ($/day)
$300 $320 $380 $480 $700
Cost of Production and Amount of Smoke Emitted
T = ton
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Price Incentives and the Environment
If there are no regulations, each firm produces at its lowest cost, production method A Each firm produces 4 tons of smoke per day
Government wants to cut pollution by half Option 1: Set maximum pollution limits Option 2: Tax smoke at a rate of $T per ton
Determine T to reduce pollution by half
Each option has costs to society that must be considered
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Reducing Pollution by Regulation
Each firm moves to production process C Costs increase $500/day for Sludge and
$80/day for NW Lumber Total cost to society of this plan is $580/day
Process (smoke)
A (4
T/day)
B(3 T / day)
C(2
T/day)
D(1
T/day)
E(0
T/day)
Sludge Oil ($/day)
$100 $200 $600 $1,300 $2,300
NW Lumber ($/day)
$300 $320 $380 $480 $700
Cost of Production and Amount of Smoke Emitted
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Taxing Pollution
If tax is $T per ton, the firms will reduce pollution as long as the cost of reductions is less than $T
A tax of $101 moves Sludge to B and NW Lumber to D
Total cost is $100 for Sludge + $180 for NW = $280/day Net savings of $300/day over regulation
Process (smoke)
A (4
T/day)
B(3 T / day)
C(2
T/day)
D(1
T/day)
E(0
T/day)
Sludge Oil ($/day)
$100 $200 $600 $1,300 $2,300
NW Lumber ($/day)
$300 $320 $380 $480 $700
Cost of Production and Amount of Smoke Emitted
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Price Incentives and the Environment
Taxing pollution concentrates pollution reduction in firms that can accomplish it at the least cost Cost – Benefit Principle Cost of the last ton of smoke removed is the
same for all firms It can be difficult to determine the
optimal tax rate Set the tax too high and you get too little
reduction Set the tax too low and you get too much
reduction Marginal cost exceeds marginal benefit to society
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Auctioning Pollution Permits
Set a target level for total pollution allowed Auction 4 permits to allow 4 tons/day
Determine price of a permit, who buys them, and the total cost of pollution reductions
Process (smoke)
A (4
T/day)
B(3 T / day)
C(2
T/day)
D(1
T/day)
E(0
T/day)
Sludge Oil ($/day)
$100 $200 $600 $1,300 $2,300
NW Lumber ($/day)
$300 $320 $380 $480 $700
Cost of Production and Amount of Smoke Emitted
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Auctioning Pollution Permits
Process (smoke)
A (4
T/day)
B(3 T / day)
C(2
T/day)
D(1
T/day)
E(0
T/day)
Sludge Oil ($/day)
$100 $200 $600 $1,300 $2,300
NW Lumber ($/day)
$300 $320 $380 $480 $700
Cost of Production and Amount of Smoke Emitted
# permits 1 2 3 4
Sludge Oil ($/day)
$1,000 $700 $400 $100
NW Lumber ($/day)
$220 $100 $60 $20
Benefit of Permits
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Auctioning Pollution Permits
At a price of $90, 6 permits are demanded 4 for Sludge and 2 for NW Lumber
At a price of $100, 5 permits are demandedAt a price of $101, 4 permits are demandedSludge uses process B and NW uses process
D
# permits 1 2 3 4
Sludge Oil ($/day)
$1,000 $700 $400 $100
NW Lumber ($/day)
$220 $100 $60 $20
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Advantages of the Auction
Utilizes low cost pollution control Permit fees can offset other taxes Total cost same as with tax; administratively simple
Predictable operating and investing environment Citizens can lobby government to set target
pollution
Process (smoke)
A (4
T/day)
B(3 T / day)
C(2
T/day)
D(1
T/day)
E(0
T/day)
Sludge Oil ($/day)
$100 $200 $600 $1,300 $2,300
NW Lumber ($/day)
$300 $320 $380 $480 $700
Cost of Production and Amount of Smoke Emitted
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Shared Living
Deena and Leena are evaluating housing options 2-bedroom apartment for $600 per month OR 2 1-bedroom apartments for $400 per month each
If the rents were the same, Deena and Leena would be indifferent between the two arrangements Except, Deena talks constantly on the phone
Deena would pay up to $250 per month to be able to use the phone whenever she wants
Leena would pay up to $150 per month to get better phone access
No second phone line is possible Should they live together?
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Benefits and Costs of Shared Living
Total Cost of Separate
Apartments
Total Cost of Shared
Apartment
Rent Savings from Sharing
$800 per month $600 per month $200 per month
Live together if the benefits exceed the costs
ProblemDeena's Cost of Solving the
Problem
Leena's Cost of Solving
the Problem
Least-Cost Solution
Deena's phone usage
Pay Deena $250 to
decrease usage
Pay Leena $150 to
tolerate Deena
Deena pays Leena $150 per month
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Net Benefit of Shared Living
Deena and Leena will live together
$200 per month
$150 per month
$50 per month
Rent SavingsCost of Phone Accommodati
on
Gain in Surplus
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Dividing the Rent
Leena would spend $400 per month to live alone The cost of tolerating Deena's phone use
is $150 per month the highest monthly rent she would be
willing to pay for the shared apartment is $400 $150 = $250
Above $250, she will be better off living aloneDeena is willing to pay up to $400
per month, the cost of living alone But the difference is $350 which is
better than paying $400 to live alone
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When Are Legal Remedies for Externalities Needed?
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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When Are Legal Remedies for Externalities Needed?
A motorist with a noisy muffler imposes costs on others Yet we cannot flag him down and offer him
a compensation payment to fix his muffler In recognition of this difficulty, most
governments simply require that cars have working mufflers
A large share of laws is to solve problems caused by externalities
The goal of such laws is to help people achieve the solutions they might have reached had they been able to negotiate with one another
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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
inspectionsZoning lawsBuilding height and footprint
regulations (sunshine laws)Air and water pollution laws
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Three Cases
Free SpeechFree speech laws recognize 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 a government
Planting TreesGovernment subsidizes trees on private property
Decreases chances of flooding and landslides
Net reduction of CO2 in the atmosphere
Basic ResearchMillions of dollars spent by federal government yearly Externalities of new
knowledge
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Optimal Amount of Negative Externalities
As pollution is reduced The marginal benefit from its reduction tends to
fall The marginal cost from its reduction tends to
increaseAs a result, the marginal cost and marginal
benefit curves almost always intersect at less than the maximum amount of pollution reduction The intersection of the two curves marks the
socially optimal level of pollution reduction This implies the existence of a socially optimal level
of pollution, and that level will almost always be greater than zero
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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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Optimal Amount of Negative Externalities
But to speak of a socially optimal level of pollution is not the same as saying that pollution is good It is to recognize that society has an
interest in cleaning up the environment, but only up to a certain point
Think of your apartment• You can spend the whole day cleaning• Or you can tolerate some amount of dirt
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Quantity (tons/year)P
rice
($00
0s /
ton
)
D
Private MC
12,000
1.3
Pollution Tax$1,000 / ton
Taxing a Negative Externality
Tax
Private MC + Tax
2.32.0
8,000
2.0
8,000
Private Equilibrium
Social Optimum
After Tax Equilibrium
Before Tax Equilibrium
Social MC
XC
Quantity (tons/year)
Pric
e ($
000s
/ t
on)
D
Private MC1.3
12,000
No Pollution Tax
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Taxing a Negative Externality
Critics insist that taxes always reduce economic efficiency This tax actually makes the economy more
efficient The tax forces producers to take explicit
account of the fact that each additional unit of output they produce imposes an external cost of $1,000 on the rest of society
Similar reasoning suggests that a subsidy to producers can serve to counteract misallocations that result from positive externalities
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Subsidizing a Positive Externality
12
Quantity (000s tons/year)
Pric
e ($
/ t
on)
Private Demand
MC
8
No Subsidy
14
10
16
Quantity (000s tons/year)
Pric
e ($
/ t
on)
Subsidy
Private Demand
MC
12
8
14
10
16
XB
Social Demand
Subsidized Demand
Subsidy
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Property Rights and the Tragedy of The Commons
People who grow up in industrialized nations tend to take the institution of private property for granted Our intuitive sense is that people have the
right to own any property they acquire by lawful means and to do with that property as they see fit
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
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The Tragedy of The Commons
Suppose 5 villagers own land suitable for grazing Each can spend $100 for either a steer or
invest in a risk-free market that pays 13% Steers graze on the commons for 1 year
before being sold in year 2 Value of the steer in year 2 depends the
weight it gained which depends on herd size Villagers make sequential decisions
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Payoff For a Steer
Using the information in the table below, each villager makes a decision
The 4th is indifferent between the two assets buys a steer
The 5th invests in the risk-free market
# Steers
Selling Price per Steer in Year 2
Income per Steer
1 126 26
2 119 19
3 116 16
4 113 13
5 111 11
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The Tragedy of The Commons
Since the first 4 villagers will send their steer to graze, their income becomes 4 * 13 = $52
The 5th villager will invest in a risk-free market and earn $13 Total income of the village is $65
Has Adam Smith’s invisible hand produced the most efficient allocation of these villagers’ resources? It has not since their total village income is $65—
precisely the same as it would have been had the possibility of cattle raising not existed
What if now villagers make their decision as a group?
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What the Villagers Did
This time the villagers’ goal is to maximize the income received by the group as a whole
Net income from the risk-free investment 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 invest in the risk-free market. Total net income is 26 + (4) (13) = $78
A net gain of $13 compared to the first scenario
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A Better Choice
# SteersSelling Price
Income per steer
Total Cattle
Income
Marginal Income
1 126 26 26 26
2 119 19 38 12
3 116 16 48 10
4 113 13 52 4
5 111 11 55 3
Tragedy of the commons is the tendency for a resource that has no price to be used until its marginal benefit is zero
The essential cause of the tragedy of the commons is the fact that one person’s use of commonly held property imposes an external cost on others by making the property less valuable
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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 steers
Villagers can borrow and lend at 13% One steer is the optimal number income of
$26Winning bidder pays $100 for the right to
use the commons Since its use generates an income of $26 per year,
or $13 more than the opportunity cost of your investment in the steer, the most you would pay is $100
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The Effect of Private Ownership
The winning bidder starts the year Spends $100 in savings to buy a year-old
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
Berries in the ParkSweetness increases as the berry ripensBerries are common property
Berries will be eaten before they are fully ripe
Other ExamplesHarvesting
Timber on remote public land
Whales in open oceansWorldwide pollution
Shared cold drinksCold drinks chill taste buds
Decrease appreciation of its flavor
Drinking slowly increases appreciation
If two people share the cold drink, 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 also relative, not only
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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Professional Athletes Take Steroids
Muntasir and Nasir compete for the gold medal Each has 50% chance at the gold
medalMuntasir and Nasir have a
Prisoner's Dilemma
Nasir's Options
Muntasir's Options
No Steroids Steroids
No Steroids 2nd best for each
Worst for Muntasir
Best for Nasir
SteroidsBest for Muntasir
Worst for Nasir3rd best for each
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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 externalities A positional arms control agreement
attempts to limit the mutually offsetting investments in performance enhancements by contestants
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Examples of Positional Arms Control Agreements
Campaign spending limitsRoster limitsArbitration agreementsMandatory starting dates for
kindergartenNerd normsFashion normsNorms of tasteNorms against vanity