1. Frank & Bernanke 3rd edition, 2007
Ch. 12: Externalities and Property Rights

2. External Costs and Benefits
External Cost (negative externality)
A cost of an activity that falls on people other than those who pursue the activity
External Benefit (positive externality)
A benefit of an activity received by people other than those who pursue the activity

3. External Costs and Benefits
How Externalities Affect Resource Allocation
Externalities reduce economic efficiency.
Solutions of externalities may be efficient.
When efficient solutions to externalities are not possible, government intervention or other collective action may be used.

4. How Externalities Affect Resource Allocation
Does 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.
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.

5. How Externalities Affect Resource Allocation
Does the honeybee keeper face the right 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.
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.

6. How Externalities Affect Resource Allocation
When 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.
When an activity generates a negative externality, the level of the activity will be greater than the socially optimal level.
When an activity generates a positive externality, the level of the activity will be less than the socially optimal level.

7. How External Costs Affect Resource Allocation
Production without external cost
Production with external cost D
Private MC
12,000
1,300
Private
equilibrium
Deadweight loss caused by
pollution = $2mil/yr
2,000
8,000
Social
optimum
2,300
XC = $1,000/ton
Social MC =
Private MC + XC
Price ($/ton)
Price ($/ton)
Quantity (tons/year)
Quantity (tons/year)

8. A Good Whose Production Generates a Positive Externality for Consumers
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
Deadweight loss from
positive externality
Price
Quantity

9. Costs and Benefits of Eliminating Toxic Waste
With filter
Without filter
Gains to
Abercrombie
$100/day
$130/day
$50/day
Gains to
Fitch
Assume Fitch and Abercrombie can communicate at no cost
Fitch offers Abercrombie $40 to use the filter
Economic surplus increases by $20
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

10. The Coase Theorem
When a market leaves cash on table there is usually a response to capture the unrealized value.

11. The 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 problems caused by externalities.

12. Example By law Abercrombie cannot dump without Fitch’s approval.
Fitch and Abercrombie can negotiate without cost.

13. Costs and Benefits of Eliminating Toxic Waste
With filter
Without filter
Gains to
Abercrombie
$100/day
$150/day
$70/day
Gains to
Fitch
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

14. Legal Remedies for Externalities
When 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.
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.

15. Quantity of Pollution abated
The Optimal Amount of Negative Externalities is Not Zero
MC/MB
MC (increasing opportunity cost) Q
MC = MB
MB (diminishing marginal utility)
Optimal amount of pollution: MC = MB
Dirty environment
Pollution free
Quantity of Pollution abated

16. Taxing a Negative Externality
Price ($/ton)
Quantity (tons/year) D
Private MC
1,300
12,000
Private equilibrium
without pollution tax
2,000
8,000
Tax = $1,000/ton
Private MC + Tax
Social MC =
Private MC + XC
XC = $1,000/ton
2,300
Social
optimum
Private
equilibrium
with pollution tax

17. Subsidizing a Positive Externality
Price ($/ton)
Quantity (tons/year)
Private demand
Social demand =
Private demand + XB 8
Private equilibrium
without subsidy MC 10 14
1,200
1,600
Private equilibrium with subsidy
Social
optimum
XB = 6
Subsidy = 6 14 MC 10 8
Subsidized demand =
Private demand + subsidy
Private demand
1,200
1,600

18. Tragedy of Commons The Problem of “Free” Resources
When no one owns property, the opportunity cost of using it is not considered.
Use of the property will increase until MB = 0.
One person’s use of the commons imposes an external cost on the others by making the property less valuable.
If the common property is privatized (auctioned) opportunity cost of additional use will be considered by the owner

19. Tragedy of Commons The Effect of Private Ownership
Zoning laws and other regulations restrict the use of private property.
The laws can be used to maximize economic surplus.
The laws can also be used to achieve an individual goal (reelection) by reducing the economic surplus.
Private ownership may be impractical because MB<MC.

20. Positional Externality
When an increase in one person’s performance reduces the expected reward of another in situations in which reward depends on relative performance
In 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.
When the payoff depends on relative performance, incentive to invest in performance activities will be excessive from a collective point of view.

21. Payoff Matrix for Steroid Consumption
Jones
Don’t take
steroids
Take
steroids
Second best for each
Best for Jones
Worst for Smith
Best for Smith
Worst for Jones
Third best for each
Don’t take
steroids
Smith
Take
steroids
Dominant strategy for each yields the third best outcome
This prisoner’s dilemma outcome is the attraction of rules banning performance enhancing drugs.

22. Positional Arms Race
A series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality
Positional Arms Control Agreements
An agreement in which contestants attempt to limit mutually offsetting investments in performance enhancements