©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 10: Externalities and Property Rights

©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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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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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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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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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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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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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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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



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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’s company produces toxic waste Laws prohibit dumping the waste in the

river UNLESS Fawzi agrees New gains matrix

With FilterWithout

Filter





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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





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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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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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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



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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



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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



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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


# 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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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



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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


42

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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Quantity of Pollution

MC & MBMC

Q

MC = MB

MB

Optimal amount of pollution


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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


48

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


49

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


57

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


58

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


59

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


60

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


61

Examples of Positional Arms Control Agreements

Campaign spending limitsRoster limitsArbitration agreementsMandatory starting dates for

kindergartenNerd normsFashion normsNorms of tasteNorms against vanity

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©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 10: Externalities and Property Rights