McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Externalities and Property Rights 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.Illustrate the tragedy of the commons and show how private ownership is a way of preventing it 6.Define positional externalities and their effects, and show how they can be remedied

9-2 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

9-3 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

9-4 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

9-5 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 Zoning laws Building height and footprint regulations (sunshine laws) Air and water pollution laws

9-6 Optimal Amount of Negative Externalities Quantity of Pollution MC & MB MC Q MC = MB MB Optimal amount of pollution

9-7 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

9-8 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

9-9 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

9-10 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

9-11 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

9-12 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

9-13 Externalities and Property Rights RemediesRemedies Coase Theorem LawsLaws Taxes & Subsidies Tragedy of the Commons Positional Externalities Effects of External Costs Effects of External Benefits