# Chapter 11 Externalities and Property Rights

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Chapter 11 Externalities and Property Rights
Additional Questions, Q. 2, 3, 4, 10

Externalities Negative Externality:
“a cost of an activity falls on people other than those who pursue the activity.” i.e., a person smokes near you, you breathe in second-hand smoke . Individuals who consider only their own costs and benefits will tend to engage too much in activities that generate negative externalities. Thus, the private equilibrium quantity is more than the social equilibrium quantity QPVT > QSOC

Externalities Positive Externality:
“a benefit of an activity received by people other than those who pursue the activity.” i.e., a person take a flu shot, it reduces the chances of infection. Individuals who consider only their own costs and benefits will tend to engage too little in activities that generate positive externalities. Thus, the private equilibrium quantity is less than the social equilibrium quantity QPVT < QSOC

Externalities Negative and positive externalities create deadweight loss. It results in a loss in economic efficiency.

Externalities Tax and subsidy is a way to increase economic efficiency resulting from externalities. They induce producers to take account of a relevant benefit and cost that they otherwise would have ignored. Thus, the private MB curve becomes the social MB curve; and the private MC curve becomes the social MC curve. As a result, improving economic efficiency and reducing the deadweight loss

Chapter 11, Problem 2 Phoebe keeps a bee farm next door to an apple orchard. She chooses her optimal number of beehives by selecting the honey output level at which her private marginal benefit from beekeeping equals her private marginal cost. a) Assume that Phoebe’s private marginal benefit and marginal cost curves from beekeeping are normally shaped. Draw a diagram of them.

a) Assume that Phoebe’s private marginal benefit and marginal cost curves from beekeeping are normally shaped. Draw a diagram of them. \$/hive Private MC Ppvt Private MB Qpvt Number of beehives No external cost and benefit is involved. The equilibrium price and quantity is socially optimal.

Phoebe’s bees help to pollinate the blossoms in the apple orchard, increasing the fruit yield. Show the social marginal benefit from Phoebe’s beekeeping in your diagram. \$/hive DWL Private MC Ppvt + XB P Soc Ppvt XB Social MB = Private MB + XB Private MB Qpvt QSoc Number of beehives External benefit (positive externality) is involved in this case. The private market is producing too little.

c) Phoebe’s bees are Africanized killer bees that aggressively sting anyone who steps into their flight path. Phoebe, fortunately, is naturally immune to the bees’ venom. Show the social marginal cost curve from Phoebe’s beekeeping in your diagram. Social MC = Private MC + XC \$/hive Private MC XC Ppvt + XC P Soc Ppvt Private MB QSoc Qpvt Number of beehives External cost (negative externality) is involved in this case. The private market is producing too much.

Indicate the socially optimal quantity of beehives on your diagram, Is it higher or lower than the privately optimal quantity? Explain. If we combine the positive and negative externality, the socially optimal number of beehives could be greater or less than the privately optimal number depending on the magnitude of the social marginal cost relative to the private marginal cost; and depending on the magnitude of the social marginal benefit relative to the private marginal benefit.

If the negative externality is negligible and the positive externality is large:
Social MC \$/hive Private MC Social MB Private MB Q pvt Q soc Number of beehives The socially optimal number of beehives, Qsoc , exceeds the privately optimal number, Qpvt.

If the negative externality is large and the positive externality is negligible:
Social MC \$/hive Private MC Social MB Private MB Q soc Q pvt Number of beehives The socially optimal number of beehives, Qsoc , is smaller than the privately optimal number, Qpvt.

Chapter 11, Problem 3 Suppose the supply curve of boom box rentals in Golden Gate Park is given by P = Q, where P is the daily rent per unit in dollars and Q is the volume of units rented in hundreds per day. The demand curve for boom boxes is 20 – 0.2Q. If each boom box imposes \$3 per day in noise costs on others, by how much will the equilibrium number of boom boxes rented exceed the socially optimal number?

Negative Externality P = 8 + 0.1Q \$/unit P = 5 + 0.1Q 20 XC PSOC Ppvt
Number of rentals Q SOC Q pvt Market Equilibrium: Q = 20 – 0.2Q Q pvt = 50 P pvt = 10 Imposition of \$3 noise cost (external cost): Social supply curve = original supply curve + 3 Social supply curve = Q Q = 20 – 0.2Q Q pvt = 40 P pvt = 12 If the negative externality (noise) is internalized into the rental, the equilibrium rental is greater than the social equilibrium rental by 10 (50 – 40)

Chapter 11, Problem 4 Refer to problem 3. How would the imposition of a tax of \$3 per unit on each daily boom box rental affect efficiency in this market? Tax is a way to increase economic efficiency resulting from externalities. Tax forces the producers to take into account the costs impose on others. Tax has the effect of raising each producer’s MC curve by the same amount as the external cost; therefore, Private MC shifts up and equals to the Social MC. Thus, the resulting private equilibrium quantity equals to the socially optimal quantity.

Thus, the imposition of a \$3 per unit tax is efficiency-enhancing
The government can use taxes as an incentive for producers to cut back on externalities, i.e. pollution. Taxes used in this way are called Pigou taxes. By setting the tax rate equal to the marginal external cost, firms can be made to behave in the same way as they would if they bore the cost of externality directly. Thus, the imposition of a \$3 per unit tax is efficiency-enhancing It actually internalizes the noise cost into the private supply curve After the imposition of tax, the supply curve becomes the social supply curve It helps bring the inefficient rental of boom boxes to the (socially) efficient rental of boom boxes

Additional Question Affordable housing is seen as a way to reduce crime rates and raise the quality of life of lower income neighborhoods. A) Given this information, what economic concept do you think is relevant to the analysis of the affordable housing market?

Affordable housing gives a positive externality
It reduces the crime rates and raises the quality of life of other people in the neighborhood Therefore, the marginal social benefit of affordable housing is greater than the marginal private benefit for owners of affordable housing

B) Graphically show the market for affordable housing
B) Graphically show the market for affordable housing. What is the market equilibrium? What is the social optimum? C) Graphically show any deadweight loss in this market.

As the marginal social benefit is greater than the marginal private benefit for affordable housing, the equilibrium quantity from a competitive market at Q1 is lower than the socially optimal quantity of Q2. DWL P2 P1

D) Discuss potential ways of reducing deadweight loss in this market.
To reduce deadweight loss in this market, the government can subsidize the ownership of affordable housing by the same amount as the external benefit, so that the number of affordable homes increases toward Q2 Subsidy is a way to increase economic efficiency resulting from externalities. It induces producers to take account of a relevant benefit that they otherwise would have ignored. Subsidy has the effect of raising each producer’s MB curve by the same amount as the external benefit; therefore, Private MB shifts up and equals to the Social MB. Thus, the resulting private equilibrium quantity equals to the socially optimal quantity

Chapter 11, Problem 10 A village has six residents, each of whom has accumulated savings of \$100. Each villager can use this money either to buy a government bond that pays 15 percent interest per year or to buy a year-old llama, send it onto the commons to graze, and sell it after 1 year. The price the villager gets for the 2-year-old llama depends on the quality of the fleece it grows while grazing on the commons. That in turn depends on the animal’s access to grazing, which depends on the number of llamas sent to the commons, as shown in the following table:

Number of llamas on the commons Price per 2-year-old llama(\$)
1 122 2 118 3 116 4 114 5 112 6 109 The villagers make their investment decisions one after another, and their decisions are public. If each villager decides individually how to invest, how many llama will be sent onto the commons, and what will be the resulting net village income? He will send llama onto the commons if the benefit is at least as large as the interest he could have earned on government bonds.

To buy a \$100 government bond, \$15 of interest will be earned, or \$115 in total. Villager should send a llama on the commons if and only if that llama will command a price of at least \$115. Therefore, 3 llamas will be sent onto the commons, 3 villagers will buy the government bond. Total village income: \$48 + 3(\$15) = \$93 Construct the table: Number of llamas on the commons Price per 2-year-old llama (\$) Income per llama (\$/yr) Total village income (\$/yr) 1 122 (122 – 100) = 22 22 2 118 18 36 3 116 16 48 4 114 14 56 5 112 12 60 6 109 9 54

What is the socially optimal number of llamas for this village
What is the socially optimal number of llamas for this village? Why is that different from the actual number? What would net village income be if the socially optimal number of llamas were sent onto the commons? To maximize the income received by the group as a whole. We need to compare the marginal income. Recall, the amount that could be earned from a government bond is \$15. Villagers should send llama onto the commons only if its marginal income is at least as large as \$15.

Number of llamas on the commons Price per 2-year-old llama (\$)
Income per llama (\$/yr) Total village income (\$/yr) 1 122 22 2 118 18 36 3 116 16 48 4 114 14 56 5 112 12 60 6 109 9 54 Marginal income (\$/yr) 22 14 12 8 4 -6 The socially optimal number is to send 1 llama onto the commons and buy 5 government bonds; instead of sending 3 llamas onto the commons and buy 3 government bonds as in part a. This is different from the actual number because in deciding whether or not to send a llama, each villager ignores the impact of his llama’s presence on the other llamas’ fleece quality. The total village income would then be \$22 + 5(\$15), \$97. That amount is \$4 more than the total amount that resulted when villagers made their investment decisions individually.

The village committee votes to auction the right to graze llamas on the commons to the highest bidder. Assuming villagers can both borrow and lend at 15 percent annual interest, how much will the right sell for at auction? How will the new owner use the right, and what will be the resulting village income? If a single villager could control access to the commons, the most profitable way to use this land is to send only a single llama, and earn \$22 per year. The opportunity cost of \$100 spend on llama is the interest could have earned from buying government bond, \$15. If the land were free, the owner would thus earn \$22 per year by raising one llama per year on it, or \$7 more than she would have earned had she used her \$100 to buy a bond.

The price of the land will be bid up until it owning the land is no better than putting the same amount in the bank at 15 percent interest. That price is the amount of money that would yield \$7 per year if deposited at 15 percent interest, that is, 0.15x = 7 x= \$46.67 Therefore, the new owner will graze one llama. The village income will be \$97; \$22 + 5(\$15).

Additional Question # 1 A cost or benefit that falls on people other than those pursuing an activity is called a(n) positive externality. negative externality. externality. external cost. external benefit Ans: C

Additional Question # 2 Which of the following is an example of a negative externality? Your neighbors enjoying the loud music you play. A firm dumping waste into a stream. Bees pollinating flowers on adjacent property. Whales swimming in international waters. None of the above. Ans: B

Additional Question # 3 A negative externality will result in an equilibrium quantity of an activity that is _____________ the socially optimal quantity. above below above or below equal to it can not be determined Ans: A

Additional Question # 4 A positive externality will result in an equilibrium quantity of an activity that is _____________ the socially optimal quantity. above below above or below equal to it can not be determined Ans: B

Additional Question # 5 Which factor, if it were present, would lessen the ability of the Coase Theorem to solve an externality? The situation is already efficient. Negotiating requires hiring a lawyer. The parties are all self-interested. The potential gain in surplus is high. Property rights have already been assigned to one of the parties. Ans: B

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 causes by externalities.” Hiring a lawyer is a kind of transaction costs – one has to spend time to find a lawyer, as well as paying the lawyer to do the negotiation. In other words, in order to exercise one’s right, the person has to incur some transaction costs. Therefore, Option B is the answer.

Additional Question # 6 Suppose there are ten people playing cards in a room. One of them wants to smoke a cigar; nine of them dislike the smell of cigar smoke. The smoker values the privilege of smoking at \$5, and each of the other nine occupants of the room would be willing to pay fifty cents for clean air in the room. The rules governing use of the room state that smoking is not allowed unless everyone agrees to allow smoking.

If the cigar smoker paid each other occupant \$0
If the cigar smoker paid each other occupant \$0.50 for the right to smoke, the cigar smoker would be ? and the other occupants would be ? . Better off; worse off. Better off; just as well off as before the payment. Better off; better off. Just as well off as before the payment; better off. Worse off; just as well off as before the payment.

According to the story:
The smoker’s reservation price for smoking is \$5. Each of other occupants’ reservation price for clean air is \$0.50. Now the smoker is paying to compensate the other occupants from the smoky air.

There are 9 other occupants. Each of them is paid \$0
There are 9 other occupants. Each of them is paid \$0.50, which is their reservation price. Before the payment, they were enjoying clean air which was valued also at \$0.50. Therefore, they are equally well off as before the payment.

The smoker’s reservation price for a drag is \$5.
He is paying \$0.50 x 9 to smoke, which amounts to \$4.50. There is a \$0.50 surplus. Hence, he is better off. Ans: B

Additional Question # 7 The reason drivers would prefer building new roads to a \$5 toll to reduce commute times is because Building roads is the only solution. They know a toll would not alter commuting behaviour. Cities always need new roads. The cost of new roads falls on all taxpayers; the toll only falls on those who use the existing road. Of the commitment problem. Ans: D

Options A and B are not right
Options A and B are not right. We know that by setting a toll, the congestion on the highway can be reduced (and solved entirely). Option C does not make any economic sense at all. Option E is also not right, as we are not talking about competition or game theory.

If a toll of \$5 is imposed, users of the highway will have to pay money out from their pocket on a ‘pay as you use’ basis. Which means the users will have to pay for what they use. This is not a problem until rational consumers realise that they can actually shift the financial burden to other people, spreading the contribution among all people in the city.

By having the government building more roads, all taxpayers in the cities are financing the project.
Probably not all taxpayers are users of that highway anyway. Frequent highway users will find out that instead of paying \$5 every single day, commuting on other people’s money (including theirs, but the cost is spread) is a bargain. And hence, Option D is the answer.

Additional Question # 8 Explain the following situations by using the concept “Tragedy of the commons”. Harvesting timber on public land Picking strawberries in a public park Harvesting whales in international oceans Environmental pollution

“Tragedy of the commons” the tendency for a resource that has no price to be used until its marginal benefit falls to zero. When no one has the private ownership to own any kind of property, i.e., land, ocean, swimming pool, he/she has no incentive to take the opportunity cost of using it into account. The cause of it is the fact that one person’s use of commonly held property imposes an external cost on others by making the property less valuable. Solutions to the tragedy of commons are to place a clearly defined property ownership and to place a regulation of the use of property.

Harvesting timber on public land
Each tree cutter knows that a tree not harvested this year will be bigger, and hence more valuable next year. But he also knows that if he doesn't cut the tree down this year, someone else will. Solution: Laws regulated the amount of harvests b) Picking strawberries in a public park Each individual knows that the strawberries would taste better if allowed to ripen for another week But each also knows that strawberries not eaten today may not be there next week. Solution: assign ownership on strawberries park

Harvesting whales in international oceans
Each individual whaler knows that harvesting an extra whale reduces the breeding population of whales Hence reduce the size of future whale populations, but he also knows that any whale he fails to harvest today will just be taken by some other whaler. Solution: Fishing license d) Environmental pollution Each individual polluter has no incentive to take into account the cost his pollution imposes on others. Solution: Tax

Additional Question # 9 People can purchase and sell the right to perform activities that cause externalities to arrive at efficient solutions. This describes the Tragedy of the Commons. a positional externality. an external benefit. the Coase Theorem. the problem of unpriced resources. Ans: D