1. ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 10: Externalities and Property Rights

2. ©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Define negative and positive externalities and analyze their effect on resource allocations 2.Explain how the effects of externalities can be remedied 3.Compare and contrast the ways in which taxes and tradable permits can be used to reduce pollution 4.Discuss why the optimal amount of an externality is not 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

3. ©2012 The McGraw-Hill Companies, All Rights Reserved 3 External Costs and Benefits External cost is a cost of an activity that is paid by 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 Externality an external cost or benefit of an activity

4. ©2012 The McGraw-Hill Companies, All Rights Reserved 4 Externalities This chapter focuses on how externalities affect the allocation of resources Adam Smith’s theory of invisible hand applies to an ideal market, in which externalities do not exist  In an ideal market, self-interested actions of individuals would lead to socially efficient outcomes In the case of externalities, when the parties affected can easily negotiate with one another, the invisible hand will still produce an efficient outcome

5. ©2012 The McGraw-Hill Companies, All Rights Reserved 5 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

6. ©2012 The McGraw-Hill Companies, All Rights Reserved 6 Honeybee Keeper – Scenario 1 Asal harvests and sells honey from her bees  Her neighbors grow apples  Bees pollinate their apple orchards The bees provide a free service to the local farmers  Asal is giving away a service  No payments made to Asal  If Asal takes only her own costs and benefits into account in deciding how many hives to keep, will she keep the socially optimal number of hives?

7. ©2012 The McGraw-Hill Companies, All Rights Reserved 7 Honeybee Keeper – Scenario 1 The bees provide a free service to the local farmers  Since the orchard owners also benefit from additional hives, the total benefit of adding another hive at that point will be greater than its cost  Private costs are equal to private benefits Asal, then, will keep too few hives  Social costs are less than social benefits When external benefits exist, maximizing private profits produces less than the social optimum

8. ©2012 The McGraw-Hill Companies, All Rights Reserved 8 Honeybee Keeper – Scenario 2 Asal 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  Asal 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

9. ©2012 The McGraw-Hill Companies, All Rights Reserved 9 External Cost Quantity (tons/year) 12,000 1.3 Price ($000s / ton) D Private MC $1,000/ton How Do Externalities Affect Supply / Demand? Price ($000s / ton) No External Cost Quantity (tons/year) 12,000 1.3 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. ©2012 The McGraw-Hill Companies, All Rights Reserved 10 How Do Externalities Affect Supply / Demand? Since the external pollution cost falls not on firm owners but on others who live downwind from their factories, Private MC is still the supply curve for this product, and its demand curve is again as before, So the equilibrium price and quantity will be exactly the same as the one represented by the left graph

11. ©2012 The McGraw-Hill Companies, All Rights Reserved 11 How Do Externalities Affect Supply / Demand? But this time the private market equilibrium is not socially optimal As before, the market equilibrium level of output is 12,000 tons per year However at that output level, the value to consumers of the last unit of output produced is only $1,300 per ton, while the true cost of producing that last unit (including the external cost) is $2,300 per ton

12. ©2012 The McGraw-Hill Companies, All Rights Reserved 12 How Do Externalities Affect Supply / Demand? This means that society could gain additional economic surplus by producing fewer units of the product  The same conclusion will continue to hold whenever the current output exceeds 8,000 (where demand curve intersects Social MC) As output expands past 8,000, the marginal cost of each successive unit (as measured on the Social MC curve) is greater than the marginal benefit of that unit (as measured on the demand curve)  This entails a reduction in total economic surplus  Deadweight loss from pollution is $2 million

13. ©2012 The McGraw-Hill Companies, All Rights Reserved 13 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

14. ©2012 The McGraw-Hill Companies, All Rights Reserved 14 How Do Externalities Affect Supply / Demand? To summarize,  Whether externalities are positive or negative distort the allocation of resources in efficient markets  When externalities are present, the individual pursuit of self-interest will not result in the largest possible economic surplus  The outcome is thus inefficient

15. ©2012 The McGraw-Hill Companies, All Rights Reserved 15 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

16. ©2012 The McGraw-Hill Companies, All Rights Reserved 16 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

17. ©2012 The McGraw-Hill Companies, All Rights Reserved 17 The Coase Theorem To say that a situation is inefficient means that it can be rearranged in a way that would make at least some people better off without harming others The existence of inefficiency means that there is cash on the table, which usually triggers a race to see who can capture it  For example, because monopoly pricing results in an inefficiently low output level, the potential for gain gave monopolists an incentive to make discounts available to price-sensitive buyers

18. ©2012 The McGraw-Hill Companies, All Rights Reserved 18 Fawaz the Polluter – Scenario 1 Fawaz’s company dumps toxic waste in the river  Fawzi cannot fish the river  No one else is harmed Fawaz could install a filter to remove the harm to Fawzi  Filter imposes costs on Fawaz  Filter benefits Fawzi Parties do not communicate

19. ©2012 The McGraw-Hill Companies, All Rights Reserved 19 Fawaz’s Filter Options With FilterWithout Filter Fawaz's Gains$100 / day$130 / day Fawzi's Gains$100 / day$50 / day Total Gains$200 / day$180 / day  Fawaz does not install the filter  Marginal cost of filter to Fawaz is $30 per day  The marginal benefit to Fawzi is $50 per day  There is a net welfare loss of $20 per day

20. ©2012 The McGraw-Hill Companies, All Rights Reserved 20 Fawaz the Polluter – Scenario 2 Communications (at no cost) changes the outcome  Fawzi pays Fawaz between $30 and $50 per day to use the filter  Net gain in total surplus of $20 per day With FilterWithout Filter Fawaz’s Gains$100 / day$130 / day Fawzi’s Gains$100 / day$50 / day Total Gains$200 / day$180 / day

21. ©2012 The McGraw-Hill Companies, All Rights Reserved 21 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 Fawaz and Fawzi  Sometimes polluter buys the right to pollute Fawaz pays Fawzi if the value of polluting is greater than the harm to Fawzi The adjustment to the externality is usually done by the party with the lowest cost

22. ©2012 The McGraw-Hill Companies, All Rights Reserved 22 The Coase Theorem Coase theorem if at no cost people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities

23. ©2012 The McGraw-Hill Companies, All Rights Reserved 23 Fawaz the Polluter – Scenario 3 Fawaz’s company produces toxic waste  Laws prohibit dumping the waste in the river UNLESS Fawzi agrees  New gains matrix With FilterWithout Filter Fawaz's Gains$100 / day$150 / day Fawzi's Gains$100 / day$70 / day Total Gains$200 / day$220 / day

24. ©2012 The McGraw-Hill Companies, All Rights Reserved 24 Fawaz the Polluter – Scenario 3 Fawaz can pay Fawzi up to $50 per day for the right to pollute  Fawzi will accept any offer over $30 per day In this scenario, polluting is the right thing to do With FilterWithout Filter Fawaz's Gains$100 / day$150 / day Fawzi's Gains$100 / day$70 / day Total Gains$200 / day$220 / day

25. ©2012 The McGraw-Hill Companies, All Rights Reserved 25 Price Incentives and the Environment Goods with negative externalities tend to be overproduced Social objective is to reduce pollution by half from its unregulated level  The most efficient solution is one where the marginal cost of pollution abatement is the same for all polluters  Cost data are not available to government  One solution is to have all reduce pollution by the same proportion  Uneven distribution of costs

26. ©2012 The McGraw-Hill Companies, All Rights Reserved 26 Price Incentives and the Environment One policy option is to tax pollution  Businesses decide how much pollution to produce 2 firms, 5 production processes each  Production differs by cost and amount of pollution Process (smoke) A (4 T/day) B (3 T / day) C (2 T/day) D (1 T/day) E (0 T/day) Sludge Oil ($/day) $100$200$600$1,300$2,300 NW Lumber ($/day) $300$320$380$480$700 Cost of Production and Amount of Smoke Emitted T = ton

27. ©2012 The McGraw-Hill Companies, All Rights Reserved 27 Price Incentives and the Environment If there are no regulations, each firm produces at its lowest cost, production method A  Each firm produces 4 tons of smoke per day Government wants to cut pollution by half  Option 1: Set maximum pollution limits  Option 2: Tax smoke at a rate of $T per ton  Determine T to reduce pollution by half Each option has costs to society that must be considered

28. ©2012 The McGraw-Hill Companies, All Rights Reserved 28 Reducing Pollution by Regulation Each firm moves to production process C  Costs increase $500/day for Sludge and $80/day for NW Lumber  Total cost to society of this plan is $580/day Process (smoke) A (4 T/day) B (3 T / day) C (2 T/day) D (1 T/day) E (0 T/day) Sludge Oil ($/day) $100$200$600$1,300$2,300 NW Lumber ($/day) $300$320$380$480$700 Cost of Production and Amount of Smoke Emitted

29. ©2012 The McGraw-Hill Companies, All Rights Reserved 29 Taxing Pollution If tax is $T per ton, the firms will reduce pollution as long as the cost of reductions is less than $T A tax of $101 moves Sludge to B and NW Lumber to D Total cost is $100 for Sludge + $180 for NW = $280/day  Net savings of $300/day over regulation Process (smoke) A (4 T/day) B (3 T / day) C (2 T/day) D (1 T/day) E (0 T/day) Sludge Oil ($/day) $100$200$600$1,300$2,300 NW Lumber ($/day) $300$320$380$480$700 Cost of Production and Amount of Smoke Emitted

30. ©2012 The McGraw-Hill Companies, All Rights Reserved 30 Price Incentives and the Environment Taxing pollution concentrates pollution reduction in firms that can accomplish it at the least cost  Cost – Benefit Principle  Cost of the last ton of smoke removed is the same for all firms It can be difficult to determine the optimal tax rate  Set the tax too high and you get too little reduction  Set the tax too low and you get too much reduction  Marginal cost exceeds marginal benefit to society

31. ©2012 The McGraw-Hill Companies, All Rights Reserved 31 Auctioning Pollution Permits Set a target level for total pollution allowed  Auction 4 permits to allow 4 tons/day Determine price of a permit, who buys them, and the total cost of pollution reductions Process (smoke) A (4 T/day) B (3 T / day) C (2 T/day) D (1 T/day) E (0 T/day) Sludge Oil ($/day) $100$200$600$1,300$2,300 NW Lumber ($/day) $300$320$380$480$700 Cost of Production and Amount of Smoke Emitted

32. ©2012 The McGraw-Hill Companies, All Rights Reserved 32 Auctioning Pollution Permits Process (smoke) A (4 T/day) B (3 T / day) C (2 T/day) D (1 T/day) E (0 T/day) Sludge Oil ($/day) $100$200$600$1,300$2,300 NW Lumber ($/day) $300$320$380$480$700 Cost of Production and Amount of Smoke Emitted # permits1234 Sludge Oil ($/day) $1,000$700$400$100 NW Lumber ($/day) $220$100$60$20 Benefit of Permits

33. ©2012 The McGraw-Hill Companies, All Rights Reserved 33 Auctioning Pollution Permits At a price of $90, 6 permits are demanded  4 for Sludge and 2 for NW Lumber At a price of $100, 5 permits are demanded At a price of $101, 4 permits are demanded Sludge uses process B and NW uses process D # permits1234 Sludge Oil ($/day) $1,000$700$400$100 NW Lumber ($/day) $220$100$60$20

34. ©2012 The McGraw-Hill Companies, All Rights Reserved 34 Advantages of the Auction Utilizes low cost pollution control  Permit fees can offset other taxes  Total cost same as with tax; administratively simple Predictable operating and investing environment Citizens can lobby government to set target pollution Process (smoke) A (4 T/day) B (3 T / day) C (2 T/day) D (1 T/day) E (0 T/day) Sludge Oil ($/day) $100$200$600$1,300$2,300 NW Lumber ($/day) $300$320$380$480$700 Cost of Production and Amount of Smoke Emitted

35. ©2012 The McGraw-Hill Companies, All Rights Reserved 35 Shared Living Deena and Leena are evaluating housing options  2-bedroom apartment for $600 per month OR  2 1-bedroom apartments for $400 per month each If the rents were the same, Deena and Leena would be indifferent between the two arrangements  Except, Deena talks constantly on the phone  Deena would pay up to $250 per month to be able to use the phone whenever she wants  Leena would pay up to $150 per month to get better phone access  No second phone line is possible  Should they live together?

36. ©2012 The McGraw-Hill Companies, All Rights Reserved 36 Benefits and Costs of Shared Living Total Cost of Separate Apartments Total Cost of Shared Apartment Rent Savings from Sharing $800 per month$600 per month$200 per month  Live together if the benefits exceed the costs Problem Deena's Cost of Solving the Problem Leena's Cost of Solving the Problem Least-Cost Solution Deena's phone usage Pay Deena $250 to decrease usage Pay Leena $150 to tolerate Deena Deena pays Leena $150 per month

37. ©2012 The McGraw-Hill Companies, All Rights Reserved 37 Net Benefit of Shared Living Deena and Leena will live together $200 per month$150 per month$50 per month Rent Savings Cost of Phone Accommodation Gain in Surplus

38. ©2012 The McGraw-Hill Companies, All Rights Reserved 38 Dividing the Rent Leena would spend $400 per month to live alone  The cost of tolerating Deena's phone use is $150 per month  the highest monthly rent she would be willing to pay for the shared apartment is $400  $150 = $250  Above $250, she will be better off living alone Deena is willing to pay up to $400 per month, the cost of living alone  But the difference is $350 which is better than paying $400 to live alone

39. ©2012 The McGraw-Hill Companies, All Rights Reserved 39 When Are Legal Remedies for Externalities Needed? 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

40. ©2012 The McGraw-Hill Companies, All Rights Reserved 40 When Are Legal Remedies for Externalities Needed? A motorist with a noisy muffler imposes costs on others  Yet we cannot flag him down and offer him a compensation payment to fix his muffler  In recognition of this difficulty, most governments simply require that cars have working mufflers  A large share of laws is to solve problems caused by externalities  The goal of such laws is to help people achieve the solutions they might have reached had they been able to negotiate with one another

41. ©2012 The McGraw-Hill Companies, All Rights Reserved 41 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

42. ©2012 The McGraw-Hill Companies, All Rights Reserved 42 Three Cases Free Speech  Free speech laws recognize 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 a government 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

43. ©2012 The McGraw-Hill Companies, All Rights Reserved 43 Optimal Amount of Negative Externalities As pollution is reduced  The marginal benefit from its reduction tends to fall  The marginal cost from its reduction tends to increase As a result, the marginal cost and marginal benefit curves almost always intersect at less than the maximum amount of pollution reduction  The intersection of the two curves marks the socially optimal level of pollution reduction  This implies the existence of a socially optimal level of pollution, and that level will almost always be greater than zero

44. ©2012 The McGraw-Hill Companies, All Rights Reserved 44 Optimal Amount of Negative Externalities Quantity of Pollution MC & MB MC Q MC = MB MB Optimal amount of pollution

45. ©2012 The McGraw-Hill Companies, All Rights Reserved 45 Optimal Amount of Negative Externalities But to speak of a socially optimal level of pollution is not the same as saying that pollution is good  It is to recognize that society has an interest in cleaning up the environment, but only up to a certain point  Think of your apartment You can spend the whole day cleaning Or you can tolerate some amount of dirt

46. ©2012 The McGraw-Hill Companies, All Rights Reserved 46 Quantity (tons/year) Price ($000s / ton) D Private MC 12,000 1.3 Pollution Tax $1,000 / ton Taxing a Negative Externality Tax Private MC + Tax 2.3 2.0 8,000 2.0 8,000 Private Equilibrium Social Optimum After Tax Equilibrium Before Tax Equilibrium Social MC XC Quantity (tons/year) Price ($000s / ton) D Private MC 1.3 12,000 No Pollution Tax

47. ©2012 The McGraw-Hill Companies, All Rights Reserved 47 Taxing a Negative Externality Critics insist that taxes always reduce economic efficiency  This tax actually makes the economy more efficient  The tax forces producers to take explicit account of the fact that each additional unit of output they produce imposes an external cost of $1,000 on the rest of society Similar reasoning suggests that a subsidy to producers can serve to counteract misallocations that result from positive externalities

48. ©2012 The McGraw-Hill Companies, All Rights Reserved 48 Subsidizing a Positive Externality 12 Quantity (000s tons/year) Price ($ / ton) Private Demand MC 8 No Subsidy 14 10 16 Quantity (000s tons/year) Price ($ / ton) Subsidy Private Demand MC 12 8 14 10 16 XB Social Demand Subsidized Demand Subsidy

49. ©2012 The McGraw-Hill Companies, All Rights Reserved 49 Property Rights and the Tragedy of The Commons People who grow up in industrialized nations tend to take the institution of private property for granted  Our intuitive sense is that people have the right to own any property they acquire by lawful means and to do with that property as they see fit 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

50. ©2012 The McGraw-Hill Companies, All Rights Reserved 50 The Tragedy of The Commons Suppose 5 villagers own land suitable for grazing  Each can spend $100 for either a steer or invest in a risk-free market that pays 13%  Steers graze on the commons for 1 year before being sold in year 2  Value of the steer in year 2 depends the weight it gained which depends on herd size  Villagers make sequential decisions

51. ©2012 The McGraw-Hill Companies, All Rights Reserved 51 Payoff For a Steer Using the information in the table below, each villager makes a decision The 4 th is indifferent between the two assets  buys a steer The 5 th invests in the risk-free market # SteersSelling Price per Steer in Year 2Income per Steer 112626 211919 311616 411313 511111

52. ©2012 The McGraw-Hill Companies, All Rights Reserved 52 The Tragedy of The Commons Since the first 4 villagers will send their steer to graze, their income becomes 4 * 13 = $52 The 5 th villager will invest in a risk-free market and earn $13  Total income of the village is $65 Has Adam Smith’s invisible hand produced the most efficient allocation of these villagers’ resources?  It has not since their total village income is $65—precisely the same as it would have been had the possibility of cattle raising not existed What if now villagers make their decision as a group?

53. ©2012 The McGraw-Hill Companies, All Rights Reserved 53 What the Villagers Did This time the villagers’ goal is to maximize the income received by the group as a whole Net income from the risk-free investment 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 invest in the risk-free market. Total net income is 26 + (4) (13) = $78  A net gain of $13 compared to the first scenario

54. ©2012 The McGraw-Hill Companies, All Rights Reserved 54 A Better Choice # Steers Selling Price Income per steer Total Cattle Income Marginal Income 112626 2119193812 3116164810 411313524 511111553  Tragedy of the commons is the tendency for a resource that has no price to be used until its marginal benefit is zero  The essential cause of the tragedy of the commons is the fact that one person’s use of commonly held property imposes an external cost on others by making the property less valuable

55. ©2012 The McGraw-Hill Companies, All Rights Reserved 55 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  income of $26 Winning bidder pays $100 for the right to use the commons  Since its use generates an income of $26 per year, or $13 more than the opportunity cost of your investment in the steer, the most you would pay is $100

56. ©2012 The McGraw-Hill Companies, All Rights Reserved 56 The Effect of Private Ownership The winning bidder starts the year  Spends $100 in savings to buy a year-old 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

57. ©2012 The McGraw-Hill Companies, All Rights Reserved 57 Property Rights and the Tragedy of Commons Berries in the Park  Sweetness increases as the berry ripens  Berries 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 Shared cold drinks  Cold drinks chill taste buds  Decrease appreciation of its flavor  Drinking slowly increases appreciation  If two people share the cold drink, it is a common good  They will drink faster than if it were a private good

58. ©2012 The McGraw-Hill Companies, All Rights Reserved 58 Positional Externalities Highest compensation goes to the best performer  Standard is also relative, not only 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

59. ©2012 The McGraw-Hill Companies, All Rights Reserved 59 Professional Athletes Take Steroids Muntasir and Nasir compete for the gold medal  Each has 50% chance at the gold medal Muntasir and Nasir have a Prisoner's Dilemma Nasir's Options Muntasir's Options No SteroidsSteroids No Steroids2 nd best for each Worst for Muntasir Best for Nasir Steroids Best for Muntasir Worst for Nasir 3 rd best for each

60. ©2012 The McGraw-Hill Companies, All Rights Reserved 60 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

61. ©2012 The McGraw-Hill Companies, All Rights Reserved 61 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