Externalities and Property Rights Chapter 12 Externalities and Property Rights

Externalities Spillover costs and benefits associated with production and consumption of certain goods and services which is not accounted for by the price system Results on others not accompanied by their actions

Externalities: Positive externalities: Negative externalities External benefits Spillover benefits A benefit of an activity received by people other than those who pursue the activity Example: Negative externalities External costs Spillover costs A cost of an activity that falls on people other than those who pursue the activity

Examples of External Costs: Power plants Paper making Farming Concert Driving Smoking

Examples of External Benefits: Honeybee keeper Park Neighborhood Infrastructure ……

Costs & Benefits: Private vs. Social Social benefits: benefit enjoyed but not paid for by other members in the society Social costs: costs to other members of the society which is not compensated

How Externalities Affect Resource Allocation Positive externality of keeping honeybees Bees pollinate the apple orchards. External benefit to the apple growers (social benefit) optimal number of hives: to the keeper vs. to the community Negative Externality of keeping honeybees Hives located near a school and nursing home may cause more people to get stung by the bees. Optimal number of hives: to the keeper vs. to the community

How Externalities Affect Resource Allocation 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. 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.

Conclusion: 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

A good whose production generates a positive externality for consumers Figure 12.2, P.314

Private Solutions to Negative Externalities Inefficiency: through rearrangement, it is possible to make at least some people better off without harming others Internalization of externality: individuals take externalities into account when making decision Coase theorem: externalities need not lead to inefficiency because individuals have an incentive to make mutually beneficial deals

Coase Theorem If, at zero 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 12.3， P.315 The Market Abercrombie’s company produces a toxic waste. If the waste is dumped into the river, Fitch cannot fish in the river. Should Abercrombie install a filter? Assume there is no communication cost between Abercrombie and Fitch

Costs and Benefits of Eliminating Toxic Waste Table 12.1, P.315 With filter Without filter Gains to Abercrombie $100/day $130/day $50/day Gains to Fitch 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 Solution: Fitch pays Abercrombie at least $30 per day. Abercrombie operates with filter. Total benefit is larger than without filter.

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

Costs and Benefits of Eliminating Toxic Waste Table 12.2, P.317 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 Socially optimal quantity of pollution is not zero

Coase Theorem: again 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.

Legal Remedies for Externalities Speed limits and traffic laws Zoning laws Limits on discharge of environmental pollutants Free speech laws Energy conserving requirements ……

Policies Toward Pollution Environmental standards - rules that protect the environment by specifying actions by producers and consumers. Emissions tax - a (Pigouvian) tax designed to reduce external costs that depends on the amount of pollution a firm produces. Tradable emissions permits - licenses to emit limited quantities of pollutants that can be bought and sold by polluters.

Taxing a Negative Externality Figure 12.3, P.322

Socially optimal pollution: Not necessarily zero

Why a Market Economy Produces Too Much Pollution

Property Rights People have the right to own any property they acquire by lawful means and to do with that property much as they see fit Lack of property rights: not including marginal cost of resource use

Marginal Income and the Socially Optimal Herd Size Number of steers on the commons Price per 2-year-old steer ($) Income per steer ($/year) Total cattle Income ($/year) Marginal Income ($/year) 1 126 26 26 26 2 119 19 38 12 3 116 16 48 10 4 113 13 52 4 5 111 11 55 3 Act individually to maximize income Act collectively to maximize village income Individual choice 4 steers = $52 1 bonds = $13 Total Income = $65 Socially optimal choice 1 steer = $26 4 bonds = $52 Total Income = $78

The Problem of Un-priced Resources When no one owns the commons, the opportunity cost of using it is not considered. Use of the commons 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.

The Effect of Private Ownership Assume Villagers can borrow and lend at 13%. The villagers decide to auction off the rights to the commons. One steer is the optimal number Income from one steer = $26. Pay $100 for the commons The $26 profit covers the cost of the loan to buy the steer at the opportunity cost of $100 or $13 Economic surplus of the village will be: (4 x $13) + $26 = $78 or (4 x $13) + $13 rent + $13 highest bidder = $78

Observations Common property is not used efficiently When the land is auctioned, the highest bidder will have an incentive to consider the opportunity cost of grazing additional steers. Private ownership may be impractical. The laws can also be used to achieve an individual goal (reelection) by reducing the economic surplus. Zoning laws and other regulations restrict the use of private property. The laws can be used to maximize economic surplus.

Examples of Property Rights and Externalities Blackberries in public parks Shared milkshakes Harvesting timber on remote public land Harvesting whales in international waters Controlling multinational environmental pollution

Positional Externalities When an increase in one person’s performance reduces the expected reward of another in situations in which reward depends on relative performance Payoffs Depend 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.