Externalities and Property Rights Chapter 10 McGraw-Hill/Irwin Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved. 1

Learning Objectives Define negative and positive externalities and analyze their effect on resource allocations Discuss and explain the Coase Theorem Explain how the effects of externalities can be remedied and discuss why the optimal amount of an externality is almost never zero Illustrate the tragedy of the commons and show how private ownership is a way of preventing it Define positional externalities and their effects, and show how they can be remedied

External Costs and Benefits An external cost is a cost of an activity that falls on people other than those who pursue the activity Also called a negative externality An externality is the name given to an external cost or external benefit of an activity An external benefit is a benefit of an activity received by people other than those who pursue the activity Also called a positive externality

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

Honeybee Keeper – Scenario 1 Phoebe harvests and sells honey from her bees Bees pollinate the apple orchards No payments made to Phoebe The bees provide a free service to the local farmers Phoebe is giving away a service Private costs are equal to private benefits Social costs are less than social benefits When external benefits exist, maximizing private profits produces less than the social optimum

Honeybee Keeper – Scenario 2 Phoebe harvests and sells honey from her bees People at a neighboring school and nursing home are bothered by bee stings The bees are a nuisance to the neighbors Phoebe 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

External Costs External Cost No External Cost Quantity (tons/year) 12,000 1.3 Price ($000s / ton) D Private MC No External Cost D Private MC Social MC 2.3 $1,000/ton Price ($000s / ton) 2.0 8,000 12,000 1.3 Quantity (tons/year) Deadweight loss from pollution = $2 M/yr Social Optimum Private Equilibrium

Positive Externality for Consumers Price Quantity Private Demand MC QPVT MBPVT Social Demand Deadweight loss from positive externality XB MBPVT + XB MBSOC QSOC Private Equilibrium Social Optimum 8

Effects of Externalities With externalities, private market outcomes do not achieve the largest possible economic surplus Cash is left on the table

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 market With externalities, actions to capture the surplus are likely

Abercrombie the Polluter – Scenario 1 Abercrombie’s company dumps toxic waste in the river Fitch cannot fish the river No one else is harmed Abercrombie could install a filter to remove the harm to Fitch Filter imposes costs on Abercrombie Filter benefits Fitch Parties do not communicate

Abercrombie's Filter Options With Filter Without Filter Abercrombie's Gains $100 / day $130 / day Fitch's Gains $50 / day Total Gains $200 / day $180 / day Abercrombie does not install the filter Marginal cost of filter to Abercrombie is $30 per day The marginal benefit to Fitch is $50 per day There is a net welfare loss of $20 per day

Abercrombie the Polluter – Scenario 2 Communication changes the outcome Fitch pays Abercrombie between $30 and $50 per day to use the filter Net gain in total surplus of $20 per day With Filter Without Filter Abercrombie's Gains $100 / day $130 / day Fitch's Gains $50 / day Total Gains $200 / day $180 / day

The Coase Theorem The Coase Theorem says that 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 Fitch pays Abercrombie Sometimes polluter buys the right to pollute Abercrombie pays Fitch The adjustment to the externality is usually done by the party with the lowest cost

Abercrombie the Polluter – Scenario 3 Abercrombie’s company produces toxic waste Laws prohibit dumping the waste in the river UNLESS Fitch agrees New gains matrix With Filter Without Filter Abercrombie's Gains $100 / day $150 / day Fitch's Gains $70 / day Total Gains $200 / day $220 / day

Abercrombie the Polluter – Scenario 3 Abercrombie can pay Fitch up to $50 per day for the right to pollute Fitch will accept any offer over $30 per day In this scenario, polluting is the right thing to do With Filter Without Filter Abercrombie's Gains $100 / day $150 / day Fitch's Gains $70 / day Total Gains $200 / day $220 / day

Laws Can Change the Outcome Suppose the law makes polluters liable for the cost of cleaning up their pollution Polluters get lower incomes Non-polluters get higher incomes With Filter Without Filter Abercrombie's Gains $100 / day $150 / day Fitch's Gains $70 / day Total Gains $200 / day $220 / day

Shared Living Ann and Betty are evaluating housing options 2-bedroom apartment for $600 per month OR 21-bedroom apartments for $400 per month each If the costs were the same, Ann and Betty would be indifferent between the two arrangements The externality here is Ann's telephone usage is high She would pay up to $250 per month to be able to use the phone whenever she wants Betty would pay up to $150 per month to get better phone access No second phone line is possible

Benefits and Costs of Shared Living Live together if the benefits exceed the costs $800 per month $600 per month $200 per month Total Cost of Separate Apartments Total Cost of Shared Apartment Rent Savings from Sharing Problem Ann's Cost of Solving the Problem Betty's Cost of Solving the Problem Least-Cost Solution Ann's phone usage Pay Ann $250 to decrease usage Pay Betty $150 to tolerate Ann Ann pays Betty $150 per month

Net Benefit of Shared Living Ann and Betty will live together Rent Savings Cost of Phone Accommodation Gain in Surplus $200 per month $150 per month $50 per month

Dividing the Rent Betty would spend $400 per month to live alone The cost of tolerating Ann's phone use is $150 per month Betty will be willing to pay up to $250 = $400 - $150 to live with Ann Above $250, she will be better off living alone Ann is willing to pay up to $400 per month, the cost of living alone

Dividing the Surplus Betty's maximum rent is $250 Ann's maximum rent is $400 If they divide the surplus ($50) equally, Betty pays $225 = $250 – $25 Ann pays $375 = $400 – 25

Legal Remedies for Externalities 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

Examples of Legal Remedies for Externalities Noise regulations (cars, parties, honking horns) Most traffic and traffic-related laws Car emission standards and inspections Zoning laws Building height and footprint regulations (sunshine laws) Air and water pollution laws

Three Cases Free Speech U.S. First Amendment recognizes 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 the government Pornography Planting Trees Government subsidizes trees on private property Decreases chances of flooding and landslides Net reduction of CO2 in the atmosphere Basic Research Millions of dollars spent by central government yearly Externalities of new knowledge

Optimal Amount of Negative Externalities Quantity of Pollution MC & MB MB MC Optimal amount of pollution MC = MB Q

Taxes and Subsidies When transaction costs prohibit negotiation: Negative externalities result in overproduction Positive externalities result in underproduction A per unit tax on output can move the market to the socially optimal output when there is a negative externality A per unit subsidy on output can move the market to the socially optimal output when there is a positive externality

Taxing a Negative Externality Quantity (tons/year) Price ($000s / ton) D Private MC 12,000 1.3 Pollution Tax $1,000 / ton Quantity (tons/year) Price ($000s / ton) D Private MC 1.3 12,000 No Pollution Tax Social MC XC Tax Private MC + Tax 2.3 2.0 8,000 2.0 8,000 Social Optimum Private Equilibrium After Tax Equilibrium Before Tax Equilibrium 28

Subsidizing a Positive Externality Quantity (000s tons/year) Price ($ / ton) Subsidy Private Demand MC No Subsidy XB Social Demand Subsidized Demand Subsidy MC 14 10 16 14 10 16 Price ($ / ton) 8 12 8 Private Demand 12 Quantity (000s tons/year) 29

Tragedy of Commons 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 This is known as the tragedy of the commons Suppose 5 villagers own land suitable for grazing Each can spend $100 for either a steer or a government bond that pays 13% Villagers know what everyone before them has done Steer graze on the commons Value of the steer in year 2 depends on herd size

Selling Price per Steer Payoff For a Steer Using the information in the table below, each villager makes a decision The fourth is indifferent between the two assets He buys a steer The fifth buys a bond # Steers Selling Price per Steer Income per Steer 1 126 26 2 119 19 3 116 16 4 113 13 5 111 11

What the Villagers Did The village has 4 steer feeding on the commons for one year At the end of the year, 4 steer sell for $113 each Total revenue for the village is (5) (113) = $565 Outcome is the same as 5 bonds They could have done better

A Better Choice # Steer Selling Price Income per steer Total Cattle Income Marginal Income 1 126 26 2 119 19 38 12 3 116 16 48 10 Net income from one bond 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 buy bonds Total net income is 26 + (4) (13) = $78 A net gain of $13 compared to the first scenario Tragedy of the commons is the tendency for a resource that has no price to be used until its marginal benefit is zero

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 steer Villagers can borrow and lend at 13%. One steer is the optimal number Winning bidder pays $100 for the right to use the commons

The Effect of Private Ownership The winning bidder starts the year Spends $100 in savings to buy a yearling 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

Property Rights and the Tragedy of Commons Blackberries in the Park Sweetness increases as the berry ripens Blackberries are common property Berries will be eaten before they are fully ripe Other Examples Harvesting Timber on remote public land Whales in open oceans Worldwide pollution controls Shared Milkshakes Milkshakes chill taste buds Decrease appreciation of its flavor Drinking slowly increases appreciation If two people share the milkshake, it is a common good They will drink faster than if it were a private good

Positional Externalities Highest compensation goes to the best performer Standard is relative, not 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

Football Players Take Steroids Smith and Jones compete for one $1 million contract Each has 50% chance at the contract Smith and Jones have a Prisoner's Dilemma Jones's Options Smith's Options No Steroids Steroids 2nd best for each Worst for Smith Best for Jones Best for Smith Worst for Jones 3rd best for each

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 externality A positional arms control agreement attempts to limit the mutually offsetting investments in performance enhancements by contestants

Examples of Positional Arms Control Agreements Campaign spending limits Roster limits Arbitration agreements Mandatory starting dates for kindergarten Social Norms as Positional Arms Control Agreements Nerd norms Fashion norms Norms of taste Norms against vanity

Externalities and Property Rights Effects of External Costs Effects of External Benefits Remedies Tragedy of the Commons Coase Theorem Positional Externalities Laws Taxes & Subsidies