Frank & Bernanke 3rd edition, 2007 Ch. 12: Externalities and Property Rights

External Costs and Benefits External Cost (negative externality) A cost of an activity that falls on people other than those who pursue the activity External Benefit (positive externality) A benefit of an activity received by people other than those who pursue the activity

External Costs and Benefits How Externalities Affect Resource Allocation Externalities reduce economic efficiency. Solutions of externalities may be efficient. When efficient solutions to externalities are not possible, government intervention or other collective action may be used.

How Externalities Affect Resource Allocation Does the honeybee keeper face the right incentives? (Part I) Bees pollinate the apple orchards. The honeybee keeper may not consider the external benefit to the apple growers when considering the optimal number of hives. If the external benefit is not considered, the bee keeper’s optimal number of hives will be less than the socially optimal number of hives.

How Externalities Affect Resource Allocation Does the honeybee keeper face the right incentives? (Part II) If the hives are located near a school and nursing home, additional hives will cause more people to get stung by the bees. For the students and nursing home residents, the bee hives create an external cost. If the external costs are not considered, the optimal number of hives for the beekeeper will be greater than the socially optimal number of hives.

How Externalities Affect Resource Allocation When an activity does not create an externality, the optimal level of the activity for the individual will equal the socially optimal level of the activity. When an activity generates a negative externality, the level of the activity will be greater than the socially optimal level. When an activity generates a positive externality, the level of the activity will be less than the socially optimal level.

How External Costs Affect Resource Allocation Production without external cost Production with external cost D Private MC 12,000 1,300 Private equilibrium Deadweight loss caused by pollution = $2mil/yr 2,000 8,000 Social optimum 2,300 XC = $1,000/ton Social MC = Private MC + XC Price ($/ton) Price ($/ton) Quantity (tons/year) Quantity (tons/year)

A Good Whose Production Generates a Positive Externality for Consumers Private Demand MC Qpvt MBPVT Without external benefits QPVT is the social optimum Social demand = Private Demand + XB XB MBSOC MBPVT + XB QSOC With external benefits the private D < social D and the private optimum is less than the social optimum Deadweight loss from positive externality Price Quantity

Costs and Benefits of Eliminating Toxic Waste With filter Without filter Gains to Abercrombie $100/day $130/day $50/day Gains to Fitch Assume Fitch and Abercrombie can communicate at no cost Fitch offers Abercrombie $40 to use the filter Economic surplus increases by $20 The Market Without filter: Total Gains = $130 + $50 = $180 With filter: Total Gains = $100 + $100 = $200 MC of the filter = $30 & MB of the filter = $50 Loss in economic surplus = $20

The Coase Theorem When a market leaves cash on table there is usually a response to capture the unrealized value.

The 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 problems caused by externalities.

Example By law Abercrombie cannot dump without Fitch’s approval. Fitch and Abercrombie can negotiate without cost.

Costs and Benefits of Eliminating Toxic Waste With filter Without filter Gains to Abercrombie $100/day $150/day $70/day Gains to Fitch Economic surplus = $200 w/filter & $220 w/o filter Fitch would gain $30 with the filter but the outcome is inefficient Abercrombie pays Fitch $40 to operate without the filter Economic surplus = $110 + $110 = $220 & both gain $10 Allowing pollution increases economic surplus

Legal Remedies for Externalities When negotiation is costless: Efficient solutions to externalities can be found. The adjustment to the externality is usually done by the party with the lowest cost. 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.

Quantity of Pollution abated The Optimal Amount of Negative Externalities is Not Zero MC/MB MC (increasing opportunity cost) Q MC = MB MB (diminishing marginal utility) Optimal amount of pollution: MC = MB Dirty environment Pollution free Quantity of Pollution abated

Taxing a Negative Externality Price ($/ton) Quantity (tons/year) D Private MC 1,300 12,000 Private equilibrium without pollution tax 2,000 8,000 Tax = $1,000/ton Private MC + Tax Social MC = Private MC + XC XC = $1,000/ton 2,300 Social optimum Private equilibrium with pollution tax

Subsidizing a Positive Externality Price ($/ton) Quantity (tons/year) Private demand Social demand = Private demand + XB 8 Private equilibrium without subsidy MC 10 14 1,200 1,600 Private equilibrium with subsidy Social optimum XB = 6 Subsidy = 6 14 MC 10 8 Subsidized demand = Private demand + subsidy Private demand 1,200 1,600

Tragedy of Commons The Problem of “Free” Resources When no one owns property, the opportunity cost of using it is not considered. Use of the property will increase until MB = 0. One person’s use of the commons imposes an external cost on the others by making the property less valuable. If the common property is privatized (auctioned) opportunity cost of additional use will be considered by the owner

Tragedy of Commons The Effect of Private Ownership Zoning laws and other regulations restrict the use of private property. The laws can be used to maximize economic surplus. The laws can also be used to achieve an individual goal (reelection) by reducing the economic surplus. Private ownership may be impractical because MB<MC.

Positional Externality When an increase in one person’s performance reduces the expected reward of another in situations in which reward depends on relative performance In a competitive situation: There is an incentive to take an action to increase the odds of winning. The overall gain to the players as a group will be zero. When the payoff depends on relative performance, incentive to invest in performance activities will be excessive from a collective point of view.

Payoff Matrix for Steroid Consumption Jones Don’t take steroids Take steroids Second best for each Best for Jones Worst for Smith Best for Smith Worst for Jones Third best for each Don’t take steroids Smith Take steroids Dominant strategy for each yields the third best outcome This prisoner’s dilemma outcome is the attraction of rules banning performance enhancing drugs.

Positional Arms Race A series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality Positional Arms Control Agreements An agreement in which contestants attempt to limit mutually offsetting investments in performance enhancements