Econ 2610: Principles of Microeconomics Yogesh Uppal

Chapter 11 Externalities and Property Rights

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

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

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

Honeybee Keeper – Scenario 2 Phoebe 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 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

External Cost Quantity (tons/year) 12, Price ($000s / ton) D Private MC $1,000/ton External Costs Price ($000s / ton) No External Cost Quantity (tons/year) 12, 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

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

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

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

Abercrombie's Filter Options With Filter Without Filter Abercrombie's Gains $100 / day$130 / day Fitch's Gains$100 / day$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

Abercrombie the Polluter – Scenario 2 Communications 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$100 / day$50 / day Total Gains$200 / day$180 / day

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 Abercrombie and Fitch Sometimes polluter buys the right to pollute Abercrombie pays Fitch if the value of polluting is greater than the harm to Fitch The adjustment to the externality is usually done by the party with the lowest cost

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$100 / day$70 / day Total Gains$200 / day$220 / day

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

Three Cases Free Speech 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 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

Optimal Amount of Negative Externalities Quantity of Pollution MC & MB MC Q MC = MB MB Optimal amount of pollution

Quantity (tons/year) Price ($000s / ton) D Private MC 12, Pollution Tax $1,000 / ton Taxing a Negative Externality Tax Private MC + Tax , ,000 Private Equilibrium Social Optimum After Tax Equilibrium Before Tax Equilibrium Social MC XC Quantity (tons/year) Price ($000s / ton) D Private MC ,000 No Pollution Tax

Subsidizing a Positive Externality 12 Quantity (000s tons/year) Price ($ / ton) Private Demand MC 8 No Subsidy Quantity (000s tons/year) Price ($ / ton) Subsidy Private Demand MC XB Social Demand Subsidized Demand Subsidy

Tragedy of 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

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 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