externalities and property rights

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Externalities and Property Rights

Chapter 11: Externalities and Property Rights Slide 2

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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

External Costs and Benefits

External Cost (negative externality)A cost of an activity that falls on people

other than those who pursue the activity


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External Benefit (positive externality)A benefit of an activity received by people

other than those who pursue the activity


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Externalities reduce economic efficiency.

Solutions of externalities may be efficient.


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When efficient solutions to externalities are not possible, government intervention or other collective action may be used.


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How Externalities Affect Resource AllocationDoes the honeybee keeper face the right

incentives? (Part I)Bees pollinate the apple orchards.The honeybee keeper may not consider the

external benefit to the apple growers when considering the optimal number of hives.


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incentives? (Part I)If the external benefit is not considered, the bee

keeper’s optimal number of hives will be less than the socially optimal number of hives.


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incentives? (Part II)If the hives are located near a school and

nursing home, additional hives will cause more people to get stung by the bees.

For the students and nursing home residents, the bee hives create an external cost.


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incentives? (Part II)If the external costs are not considered, the

optimal number of hives for the beekeeper will be greater than the socially optimal number of hives.


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How Externalities Affect Resource AllocationWhen an activity does not create an

externality, the optimal level of the activity for the individual will equal the socially optimal level of the activity.


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How Externalities Affect Resource AllocationWhen an activity generates a negative

externality, the level of the activity will be greater than the socially optimal level.


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How Externalities Affect Resource AllocationWhen an activity generates a positive

externality, the level of the activity will be less than the socially optimal level.


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How External Costs Affect Resource Allocation

Pric

e ($

/ton)

Quantity (tons/year)

Pric

e ($

/ton)

DD

Private MC

12,000

1,300Private MCwith pollution

12,000

1,300

Privateequilibrium

Quantity (tons/year)

2,000

8,000Social

optimum

2,300XC = Pollution cost = $1,000/ton

Social MC =Private MC + XC

Production without external cost Production with external cost


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A Good Whose Production Generates a Positive Externality for Consumers

Pric

e

Quantity

Private Demand

MC

Qpvt

MBPVT

• Without external benefits QPVT is the social optimum

Social demand = Private Demand + XB

XB

MBSOC

MBPVT + XB

QSOC

• With external benefits the private D < social D and the private optimum is less than the social optimum


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The Coase TheoremWhen a market leaves cash on table there

is usually a response to capture the unrealized value.


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ExampleWill Abercrombie dump toxins in the river

(Part I)


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ExampleThe Market

Abercrombie’s company produces a toxic waste.

If the waste is dumped into the river, Fitch cannot fish the river.

Should Abercrombie install a filter?o Assume there is no communication between

Abercrombie and Fitch


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Costs and Benefits of Eliminating Toxic Waste (Part 1)

$100/day $130/day

$100/day $50/day

With filter Without filterGains toAbercrombie

Gains toFitch

The Market•Without filter: Total Gains = $130 + $50 = $180•With filter: Total Gains = $100 + $100 = $200•MC of the filter = $30 & MB of the filter = $50•Loss in economic surplus = $20


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$100/day $130/day

$100/day $50/day


Gains toFitch

Assume•Fitch and Abercrombie can communicate at no cost•Fitch offers Abercrombie $40 to use the filter•Economic surplus increases by $20



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The Coase TheoremIf 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 problems caused by externalities.


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QuestionWhy should Fitch pay Abercrombie to filter

out toxins that would not be there in the first place if not for Abercrombie’s factory?


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ExampleBy law Abercrombie cannot dump without

Fitch’s approval.Fitch and Abercrombie can negotiate

without cost.


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$100/day $150/day

$100/day $70/day


Gains toFitch

•Economic surplus = $200 w/filter & $220 w/o filter•Fitch would gain $30 with the filter but the outcome is inefficient•Abercrombie pays Fitch $40 to operate without the filter•Economic surplus = $110 + $110 = $220 & both gain $10•Allowing pollution increases economic surplus


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When polluters are liable:Polluter’s income is lowered.Those injured by pollution will have higher

income.


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The Gain in Surplus from Shared Living Arrangements

Least costlyProblem Ann’s cost of Betty’s cost of solution to

solving problem solving problem the problem

Total cost ofseparate apartments

(2)($400/month) $600/month $200/month= $800/month

Total cost ofshared apartment

Rent savings From sharing

Benefits of Shared Living

Costs of Shared Living

Ann’s phone usage Curtailed Tolerate phone Betty toleratesphone usage: usage: $150/mo. Ann’s phone

usage: $250/mo. $150/mo.

Gain in Surplus from Shared Living

Rent savings Least costly accommodation Gain in surplus($200/month) to shared living problems $50/month

($150/month)

Will Ann and Betty Share an apartment?


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The Gain in Surplus from Shared Living Arrangements

Least costlyProblem Ann’s cost of Betty’s cost of solution to

solving problem solving problem the problem

Total cost ofseparate apartments

(2)($400/month) $600/month $200/month= $800/month

Total cost ofshared apartment

Rent savings From sharing

Benefits of Shared Living

Costs of Shared Living

Ann’s phone usage Curtailed Tolerate phone Betty toleratesphone usage: usage: $150/mo. Ann’s phone

usage: $250/mo. $150/mo.

Gain in Surplus from Shared Living

Rent savings Least costly accommodation Gain in surplus($200/month) to shared living problems $50/month

($150/month)

How much should Ann and Betty pay if theyagree to split their economic surplus equally?


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Legal Remedies for ExternalitiesWhen negotiation is costless:

Efficient solutions to externalities can be found.The adjustment to the externality is usually

done by the party with the lowest cost.


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Legal Remedies for ExternalitiesWhen 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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Economic NaturalistWhat is the purpose of speed limits and

traffic laws?


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Economic NaturalistWhy do most communities have zoning

laws?


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Economic NaturalistWhy do many governments enact laws that

limit the discharge of environmental pollutants?


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Economic NaturalistWhat is the purpose of free speech laws?


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Economic NaturalistWhy does government subsidize the

planting of trees on hillsides?


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The Optimal Amount of Negative Externalities is Not Zero

Quantity of Pollution

MC/MBMC (increasing opportunity cost)

Q

MB = MB

MB (diminishing marginal utility)

Optimal amount of pollution: MC = MB


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The Problem of Unpriced ResourcesWhen no one owns property, the

opportunity cost of using it is not considered.

Use of the property will increase until MB = 0.

Property Rights and the Tragedy of Commons


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Number of steerson the commons

1 126 262 119 19

3 116 164 113 135 111 11

Price per 2-year-old steer($)

Income per steer($/year)

A village has:• 5 residents• Each has savings = $100• Each villager can buy a bond paying 13%/yr or a steer and sell it in a year

• Investment decisions are individual and public

Will there be a socially optimal outcome?

The Relationship BetweenHerd Size and Steer Price

Individual choice• 4 steers = $52• 1 bonds = $13• Total Income = $65

Act individually to maximize income


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Marginal Income and theSocially Optimal Herd Size

1 126 26 2626

2 119 19 3812

3 116 16 4810

4 113 13 52 45 111 11 55 3

Act collectively tomaximize village incomeSocially optimal choice• 1 steer = $26• 4 bonds = $52• Total Income = $78

Individual choice• 4 steers = $52• 1 bonds = $13• Total Income = $65

Number of steerson the commons

Price per2-year-old steer

($)

Incomeper steer($/year)

Total cattleIncome($/year)

MarginalIncome($/year)

Act individually to maximize income


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When no one owns the commons, the opportunity cost of using it is not considered.

Use of the commons will increase until MB = 0.


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One person’s use of the commons imposes an external cost on the others by making the property less valuable.


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The Effect of Private OwnershipExample

How much will the right to control the village commons sell for?


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The Effect of Private OwnershipAssume

Villagers can borrow and lend at 13%.The villagers decide to auction off the rights to

the commons.One steer is the optimal number


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The Effect of Private OwnershipAssume

Income from one steer = $26.Pay $100 for the commons

o The $26 profit covers the cost of the loan to buy the steer at the opportunity cost of $100 or $13

Economic surplus of the village will be:o (4 x $13) + $26 = $78 oro (4 x $13) + $13 rent + $13 highest bidder = $78


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The Effect of Private OwnershipObservations

When the land is auctioned, the highest bidder will have an incentive to consider the opportunity cost of grazing additional steers.

Common property is not used efficiently.


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Zoning laws and other regulations restrict the use of private property.

The laws can be used to maximize economic surplus.


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The laws can also be used to achieve an individual goal (reelection) by reducing the economic surplus.


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Private ownership may be impractical. Economic Naturalist

Why do blackberries in public parks get picked too soon?

Why are shared milkshakes consumed too quickly?


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When Private Ownership is ImpracticalHarvesting timer on remote public landHarvesting whales in international watersControlling multinational environmental

pollution


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Positional Externalities

When Payoffs Depend on Relative PerformanceIn a competitive situation:

There is an incentive to take an action to increase the odds of winning.

The overall gain to the players as a group will be zero.


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When Payoffs Depend on Relative PerformanceIn a competitive situation:

When the payoff depends on relative performance, incentive to invest in performance activities will be excessive from a collective point of view.


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Economic NaturalistWhy do football players take anabolic

steroids?Smith and Jones are competing for a single

position and a $1 million contract.


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Payoff Matrix forSteroid Consumption

Each has 50%chance of winning Jones Wins

Smith Wins Each has a 50%chance of winning

Don’t takesteroids

Jones

Smith

Takesteroids

Don’t takesteroids

Takesteroids

•Dominant strategy for each yields the third best outcome•This prisoner’s dilemma outcome is the attraction of rules banning performance enhancing drugs.


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Positional ExternalityWhen an increase in one person’s

performance reduces the expected reward of another in situations in which reward depends on relative performance


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Economic NaturalistWhy do grocery stores stay open all night,

even in small towns?


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Economic NaturalistTwo stores considering whether or not to

stay open until 1:00 a.m.


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Payoff Matrix for Extended Shopping Hours

Second bestfor each

Best for WegmansWorst for Tops

Best for TopsWorst for Wegmans

Third best for each

Close atmidnight

Wegmans

Tops

Close at1:00 A.M.

Close atmidnight

Close at1:00 A.M.

•Customers will choose the store with the most convenient hours, assuming all other variables are the same

•Both stores will stay open•Why will they stay open 24 hours?•Could a local law solve their problem?


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Positional Arms RaceA series of mutually offsetting investments

in performance enhancement that is stimulated by a positional externality?


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Positional Arms Control AgreementsAn agreement in which contestants attempt

to limit mutually offsetting investments in performance enhancements


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Positional Arms Control AgreementsCampaign spending limitsRoster limitsArbitration agreementsMandatory starting dates for kindergarten


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Social Norms as Positional Arms Control AgreementsNerd normsFashion normsNorms of tasteNorms against vanity

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End ofChapter

externalities and property rights

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