McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 10 Externalities and Property Rights

10 - 2LO 10 - All Learning Objectives 1.Define negative and positive externalities and analyze their effect on resource allocations 2.Discuss and explain the Coase Theorem 3.Explain how the effects of externalities can be remedied 4.Discuss why the optimal amount of an externality is almost never 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

10 - 3LO External Costs and Benefits  External cost is a cost of an activity that is paid by on 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

10 - 4LO 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

10 - 5LO 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

10 - 6LO Honeybee Keeper – Scenario 2  Phoebe harvests and sells honey from her bees  Neighboring school and nursing homes 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

10 - 7LO External Cost Quantity (tons/year) 12, Price ($000s / ton) D Private MC $1,000/ton External Costs Price ($000s / ton) No External Cost Quantity (tons/year) 12, D Private MC Private Equilibrium Private Equilibrium Deadweight loss from pollution = $2 M/yr Deadweight loss from pollution = $2 M/yr Social Optimum Social Optimum 2.3 Social MC 2.0 8,000

10 - 8LO Positive Externality for Consumers Deadweight loss from positive externality Deadweight loss from positive externality XB MB PVT + XB Social Demand MB SOC Q SOC Price Quantity Private Demand MC Q PVT MB PVT Private Equilibrium Private Equilibrium Social Optimum Social Optimum

10 - 9LO Effects of Externalities With externalities, private market outcomes do not achieve the largest possible economic surplus Cash is left on the table With externalities, private market outcomes do not achieve the largest possible economic surplus Cash is left on the table

LO 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

LO 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

LO Abercrombie's Filter Options With FilterWithout Filter Abercrombie's Gains$100 / day$130 / day Fitch's Gains$100 / day$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

LO Abercrombie the Polluter – Scenario 2  Communications 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 FilterWithout Filter Abercrombie's Gains$100 / day$130 / day Fitch's Gains$100 / day$50 / day Total Gains$200 / day$180 / day

LO 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 Abercrombie and Fitch  Sometimes polluter buys the right to pollute  Abercrombie pays Fitch if the value of polluting is greater than the harm to Fitch  The adjustment to the externality is usually done by the party with the lowest cost

LO 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 FilterWithout Filter Abercrombie's Gains$100 / day$150 / day Fitch's Gains$100 / day$70 / day Total Gains$200 / day$220 / day

LO 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 FilterWithout Filter Abercrombie's Gains$100 / day$150 / day Fitch's Gains$100 / day$70 / day Total Gains$200 / day$220 / day

LO 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 FilterWithout Filter Abercrombie's Gains$100 / day$150 / day Fitch's Gains$100 / day$70 / day Total Gains$200 / day$220 / day

LO Shared Living  Ann and Betty are evaluating housing options  2-bedroom apartment for $600 per month OR  2 1-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

LO Benefits and Costs of Shared Living $800 per month$600 per month$200 per month Total Cost of Separate Apartments Total Cost of Shared Apartment Rent Savings from Sharing  Live together if the benefits exceed the costs 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

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

LO 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

LO 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

LO 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

LO 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

LO Three Cases Free Speech  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 CO 2 in the atmosphere Basic Research  Millions of dollars spent by federal government yearly  Externalities of new knowledge

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

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

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

LO 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  Suppose 5 villagers own land suitable for grazing  Each can spend $100 for either a steer or a government bond that pays 13%  Villagers make sequential decisions  They know what everyone before them has done  Steers graze on the commons  Value of the steer in year 2 depends on herd size

LO 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 # SteersSelling Price per SteerIncome per Steer

LO What the Villagers Did  The village has 4 steers feeding on the commons for one year  At the end of the year, 4 steers 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

LO A Better Choice # Steers Selling Price Income per steer Total Cattle Income Marginal Income  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

LO 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  Winning bidder pays $100 for the right to use the commons

LO 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

LO 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

LO 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

LO 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 SteroidsSteroids No Steroids2 nd best for each Worst for Smith Best for Jones Steroids Best for Smith Worst for Jones 3 rd best for each

LO 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

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

LO 10 - All Externalities and Property Rights RemediesRemedies Coase Theorem LawsLaws Taxes & Subsidies Tragedy of the Commons Positional Externalities Effects of External Costs Effects of External Benefits