© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko “The Economic Way of Thinking” 11 th Edition Chapter 12: Externalities and Conflicting Rights

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 34 Chapter 12 Outline Introduction Externalities, Negative and Positive Perfection is Unattainable Negotiation Reducing Externalities Through Adjudication The Case of the Complaining Homeowner

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 34 Chapter 12 Outline The Importance of Precedents The Problem of Radical Change Reducing Externalities Through Legislation Minimizing Costs Another Approach: Taxing Emissions Licenses to Pollute

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 34 Chapter 12 Outline Efficiency and Fairness The Bubble Concept Rights and the Social Problem of Pollution Traffic Congestion as an Externality

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 34 Introduction Decision Making –Individuals choose their courses of action by weighing the expected marginal benefits of any decision against its expected marginal costs. –To affect the decision, benefits and costs for others must matter to the actor.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 34 Externalities, Negative and Positive External Costs (spillover costs) –Negative externalities –Costs not considered in decision making. Congestion caused by slow drivers creates extra travel time.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 34 Perfection Is Unattainable Negative externalities cannot be completely eliminated. –Transaction costs Are the costs of arranging contracts or transaction agreements between suppliers and demanders.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 34 Perfection is Unattainable Scenario –Motorcycle rider leaves home early in the morning. –Imposes on neighbors still asleep. Question –Why don’t they pay him to push his cycle out of the neighborhood prior to starting it?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 34 Perfection is Unattainable Internalizing Externalities –When individuals take into account the externality when making a decision.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 34 Perfection is Unattainable Industrialized Societies –Negative externalities multiply. –Civil people ignore negative externalities. –Must cultivate civic virtues. Empathy Courtesy Humility Tolerance

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 34 Negotiation Negotiation is used to minimize social problems created by negative externalities. Negotiation produces mutual gains from exchange. Failure to negotiate creates high costs to others.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 34 Negotiation Clearly defined property rights provide the basis for negotiation.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 34 Reducing Externalities Through Adjudication Adjudication –A process for deciding who has which rights. –Clarifies property rights. Question –Which would happen if no one knew what to do or what to expect from others?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 34 The Case of the Complaining Homeowner Person buys a house. Airport is built nearby creating noise. Should the owner be compensated for the costs created by the airplanes?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 34 The Case of the Complaining Homeowner Questions –Would compensating one require compensating others? –Is this heavy cost on airlines and airports justifiable? –If we correct this one, do we correct all negative externalities?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 34 The Importance of Precedents Compensation for Negative Externalities –Virtually impossible to do. –Expectations indicate property rights. Court Decisions –There is no error when the decision creates the rights. –Error is possible when the decision seeks to discover the rights.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 34 The Importance of Precedents Adjudication –Tries to avoid unexpected outcomes. –Tries to support expectations that are most widely and confidently held. –Tries to maintain a continuity of expectations.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 34 The Problem of Radical Change Technology sometimes forces rapid changes. –New rules must be formed if negative externalities rapidly multiply. Rising incomes have created changes in property rights. –Cost of pollution has changed.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 34 The Problem of Radical Change We now place a high value on clean air. –Clean air as a right. –Requires new rules.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 34 Reducing Externalities Through Legislation The creation of new rules is legislation. –Legislation clarifies property rights –Changing the rules of the game always raises the question of fairness and compels major changes in behavior.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 34 Reducing Externalities Through Legislation The challenge for a society is to legislate –To avoid gross injustices –Minimize cost of achieving objectives

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 34 Minimizing Cost Minimizing cost isn’t the only consideration when government officials are trying to achieve some objective. Fairness is also a criterion for the evaluation of government decisions.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 34 Another Approach: Taxing Emissions It is difficult at times for government agencies to determine unit cost. Polluters have an incentive to exaggerate their costs. To resolve this kind of information scarcity in the least costly manner, the EPA could impose a tax per unit of emissions.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 34 Another Approach: Taxing Emissions Pollution is a spillover cost, a cost not borne by its producer. If the per unit cost of a pollutant is set equal to the spillover cost per unit, then the creator of the costs is made to bear them. With the tax, less pollution will occur. Question –At what point would pollution cease?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 34 Another Approach: Taxing Emissions The task of the EPA is to compare the marginal cost of reducing the emissions with the marginal benefits.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 34 License to Pollute Most pollution is: –A cost. –Not a crime. Pollution tax becomes a –License to pollute.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 34 Efficiency and Fairness Some people object to taxes on pollutants because they regard such taxes as unfair. –They supposedly place the whole burden of the tax on the poor, while allowing the rich to go on fouling the environment. It must be shown that the efficient solution can be achieved while settling the fairness issue in different ways.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 28 of 34 Efficiency and Fairness Some people –Object to pollution taxes as unfair Tax burden to the poor Allow the rich to foul the environment. An efficient and fair solution is achievable. The tax approach is –In general superior vs. physical restrictions.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 29 of 34 Bubble Effect Concept A giant bubble exists over the whole firm –Control total emissions into the bubble. Under this policy firms –Allow emissions to rise if control is costly. –Making up where control is less costly. Environmentalists – no one owned the right to pollute.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 30 of 34 Rights and Social Problem of Pollution Pollution –A major social and political concern. –People disagree about rights. Demand for any good –Never completely inelastic. –Including clean air. Control should be avoided –People should choose pollution reduction which lowers costs to themselves.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 31 of 34 Traffic Congestion as an Externality Traffic congestion –Negative externality –Cost generated when ignored in decision process –Only recognize cost others create –If motorists had to pay Marginal congestion cost Drive when benefits exceeded costs

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 32 of 34 Traffic Congestion as an Externality How can externalities be internalized? –Pricing (for congestion) –Tolls –Gasoline Taxes Road construction Not for use

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 33 of 34 Once Over Lightly Spillover Costs – from people’s actions. Spillover Costs = Externalities Transaction Costs prevent negotiations. Negotiation used to secure cooperation. Clearly defined property rights ease negotiations. Some pollution reduction activity is more efficient than others.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 34 of 34 End of Chapter 12 QUESTIONS?