Steven Landsburg, University of Rochester Chapter 13 External Costs and Benefits Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Applications, 6th edition2 Introduction Externalities –Negative External costs Factory smoke –Positive External benefits Pleasure from Christmas decorations

Landsburg, Price Theory and Applications, 6th edition3 Costs Imposed on Others The doctor and the confectioner –Tax confectioner –Improve social welfare –Criticize policy prescription Private versus social marginal cost –Costs imposed on others

Landsburg, Price Theory and Applications, 6th edition4 EXHIBIT 13.1Private Costs versus Social Costs

Landsburg, Price Theory and Applications, 6th edition5 Pigou’s Analysis Take into account costs imposed on others –Internalize externality Taxation as incentive Pigou tax –Tax equal to amount of externality –Socially optimal output –Liable Property right Transactions costs

Landsburg, Price Theory and Applications, 6th edition6 EXHIBIT 13.2A Pigou Tax

Landsburg, Price Theory and Applications, 6th edition7 Coase Theorem No transactions costs The doctor and the confectioner revisited –Payments to offset harm done Side payments or bribes Private and social costs Property rights Alternative solutions

Landsburg, Price Theory and Applications, 6th edition8 EXHIBIT 13.4Alternative Assignments of Property Rights

Landsburg, Price Theory and Applications, 6th edition9 Coase Theorem with Many Firms Apply to entire industry Coase objections to Pigovian tax –Alternative solutions –Achievement of optimal outcome Ex. smoking ban in bars –Potential reduction in social welfare

Landsburg, Price Theory and Applications, 6th edition10 External Benefits Analogous to external cost analysis Pigou subsidy Application of Coase theorem Ex. fable of the bees Income effect and Coase theorem –Strong and weak Coase theorem

Landsburg, Price Theory and Applications, 6th edition11 Transactions Costs Presence of transactions costs –No negotiations possible Setting liability and assigning property rights Economic efficiency as solution to problem Reciprocal nature of problem

Landsburg, Price Theory and Applications, 6th edition12 Sources of Transactions Costs Principal-agent problem Incomplete property rights Liability rules Free riding

Landsburg, Price Theory and Applications, 6th edition13 Law and Economics English and U.S. courts Common law Liability rules and property rights –Promote economic efficiency Least expensive way solve problem Reduce transactions costs

Landsburg, Price Theory and Applications, 6th edition14 Law of Torts Acts that injure others Standards of liability –Negligence –Contributory negligence –Strict liability Criminal penalties and punitive damages –Punitive damages

Landsburg, Price Theory and Applications, 6th edition15 Positive Theory Posner believe court position predictable –Based on economic efficiency “Whose ox is being gored?” General average –Distribution of losses Respondeat superior –Employer’s liability for employee conduct

Landsburg, Price Theory and Applications, 6th edition16 Normative Theories Law should see economic efficiency Contrary to Coase and Posner Good Samaritan rule –Bystander duty to stranger in distress

Landsburg, Price Theory and Applications, 6th edition17 Optimal Systems of Law Maintain system of well-defined property rights Inefficient outcomes possible Reasonable man standard