1. Externalities and Property Rights
Chapter 10
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2. 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
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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)
Private
Equilibrium
Deadweight loss from
pollution = $2 M/yr
Social
Optimum
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8. 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
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9. Effects of Externalities
With externalities, private market outcomes do not achieve the largest possible economic surplus
Cash is left on the table
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10. 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
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11. 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
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12. 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
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13. 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
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14. 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
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15. 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
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16. 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
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17. 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
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18. 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
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19. 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
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20. Net Benefit of Shared Living
Rent Savings
Cost of Phone Accommodation
Gain in Surplus
$200 per month
$150 per month
$50 per month
Ann and Betty will live together
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21. 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
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22. 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
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23. 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
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24. 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
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25. Three Cases Free Speech Planting Trees
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 federal government yearly
Externalities of new knowledge
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26. Optimal Amount of Negative Externalities
Quantity of Pollution
MC & MB MB MC
Optimal amount of pollution
MC = MB Q
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27. 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
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28. 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 ($000s / ton) D
Private MC
1.3
12,000
No Pollution Tax
Social MC XC
Tax
Private MC + Tax
2.3
2.0
8,000
2.0
8,000
Social Optimum
Private Equilibrium
After Tax Equilibrium
Before Tax Equilibrium
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29. Subsidizing a Positive Externality
Quantity (000s tons/year)
Price ($ / 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)
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30. Tragedy of the 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
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31. 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
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32. 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
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33. 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
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34. 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
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35. 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
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36. 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
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37. 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
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38. 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
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39. 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
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40. 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
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41. The Tragedy of the Anti-Commons (1)
Tragedy of the Commons: individual right of use, but no right of exclusion
Tragedy of the Anti-commons: Individual right of exclusion but no autonomous right of use
Hold-out and hold-up problems
Examples: research, pharmaceutical companies, highway construction through private properties, international financial crises and refugee crisis.

42. The Tragedy of the Anti-Commons (2)
An example
One pharmaceutical company (PhC) and two patent holders (PHs) of drug components. PhC faces demand
and incurs costs
where w1 and w2 are the royalty fees charged separately by the patent holders. PhC strives for maximum profits:

43. The Tragedy of the Anti-Commons (3)
Each PH faces demand
and maximizes her own benefit:
The first order conditions yield:

44. The Tragedy of the Anti-Commons (4)
Had the PHs merged the PhC’s profit maximization would become:
The PH’s objective function would be:

45. The Tragedy of the Anti-Commons (5)
Comparing Qs and Ps shows that less rather than more competition would result in larger quantities and lower prices.
Comparing the PhC’s and the PHs’ profits shows that all of them would earn larger profits after than before the merger.
Tragedy of the Commons: underpricing and over-production
Tragedy of the Anti-Commons: overpricing and under-production