The Economic Way of Thinking 10e ©Prentice Hall “The Economic Way of Thinking” 10 th Edition by Paul Heyne, Peter Boettke, and David Prychitko “Externalities and Conflicting Rights” PowerPoint Slides prepared by Assistant Professor Paul Harris Camden County College

The Economic Way of Thinking 10e ©Prentice Hall Chapter Outline I.Introduction II.Externalities, Negative and Positive III.Perfection is Unattainable IV.Negotiation V.Reducing Externalities Through Adjudication VI.The Case of the Complaining Homeowner I.Introduction II.Externalities, Negative and Positive III.Perfection is Unattainable IV.Negotiation V.Reducing Externalities Through Adjudication VI.The Case of the Complaining Homeowner

The Economic Way of Thinking 10e ©Prentice Hall VII.The Importance of Precedents VIII.The Problem of Radical Change IX.Reducing Externalities Through Adjudication X.The Case of the Complaining Homeowner XI.The Importance of Precedents XII.The Problem of Radical Change XIII.Reducing Externalities Through Legislation Chapter Outline

The Economic Way of Thinking 10e ©Prentice Hall XIV.Minimizing Costs XV.Another Approach: Taxing Emissions XVI.Licenses to Pollute? Efficiency and Fairness XVII. Efficiency and Fairness XVIII. The Bubble Concept XIX.Rights and the Social Problem of Pollution XX.Traffic Congestion as an Externality XXI.Once Over Lightly Chapter Outline

The Economic Way of Thinking 10e ©Prentice Hall Introduction  Decision Making  Individuals weigh their courses of action by weighing the expected marginal benefits of any action by its expected marginal cost.  Benefits and costs must matter to the actor to affect decisions.  Decision Making  Individuals weigh their courses of action by weighing the expected marginal benefits of any action by its expected marginal cost.  Benefits and costs must matter to the actor to affect decisions.

The Economic Way of Thinking 10e ©Prentice Hall Externalities, Negative and Positive  External Costs (spillover costs)  Negative externalities  Costs not considered in decision making  Congestion caused by slow drivers creates extra travel time.

The Economic Way of Thinking 10e ©Prentice Hall  External Benefits (spillover benefits)  Positive Externalities  Benefits not considered in decision making  Example  House maintenance Externalities, Negative and Positive QuestionQuestion –Does loud music create a positive or a negative externality?

The Economic Way of Thinking 10e ©Prentice Hall Negative externalities cannot be completely eliminated.Negative externalities cannot be completely eliminated. –Transaction costs Are the cost of arranging contracts or transaction agreements between suppliers and demanders.Are the cost of arranging contracts or transaction agreements between suppliers and demanders.

The Economic Way of Thinking 10e ©Prentice Hall Perfection Is Unattainable ScenarioScenario –Motorcycle rider leaves home early in the morning –Imposes costs on neighbors QuestionQuestion –Why don’t they pay him to push his cycle out of the neighborhood prior to starting it?

The Economic Way of Thinking 10e ©Prentice Hall Internalizing ExternalitiesInternalizing Externalities –When individuals take into account the external costs (benefits) when making a decision Perfection Is Unattainable

The Economic Way of Thinking 10e ©Prentice Hall  Industrialize Societies  Negative externalities multiply  People ignore negative externalities  Must cultivate civic virtues  Empathy  Tolerance

The Economic Way of Thinking 10e ©Prentice Hall Negotiation  Negotiation is used to minimize social problems created by negative externalities.  Negotiation produces mutual gains from exchange.  Failure to Negotiate  Creates high costs to others

The Economic Way of Thinking 10e ©Prentice Hall  Question  Does negotiation occur if an isolationist moves to a rural area?  Effective Negotiation  Requires clearly defined property rights.  Clearly defined property rights provide the basis for negotiation  Clearly defined property rights provide the basis for negotiation. Negotiation

The Economic Way of Thinking 10e ©Prentice Hall Reducing Externalities Through Adjudication Adjudication A process for deciding who has which rights Clarifies property rights Question What would happen if no one knew what to do or what to expect from others? Adjudication A process for deciding who has which rights Clarifies property rights Question What would happen if no one knew what to do or what to expect from others?

The Economic Way of Thinking 10e ©Prentice Hall The Case of the Complaining Homeowner Scenario Person buys a house Airport is built nearby creating noise Should the owner be compensated for the costs created by the airplanes?

The Economic Way of Thinking 10e ©Prentice Hall Price per passenger Number of passengers D MC Q1Q1 P1P1 MC noise tax P2P2 Q2Q2 The Case of the Complaining Homeowner

The Economic Way of Thinking 10e ©Prentice Hall Questions Would compensating one require compensating others? Is this heavy cost on airlines and airports justifiable? If we correct this one, do we correct all negative externalities?

The Economic Way of Thinking 10e ©Prentice Hall The Importance of Precedents Compensation for Negative Externalities Virtually impossible to do Expectations indicate property rights Court Decisions There is no error when the decision creates the rights. Error is possible when the decision seeks to discover the rights.

The Economic Way of Thinking 10e ©Prentice Hall Adjudication Tries to avoid unexpected outcomes Tries to support expectations that are widely and confidently held Tries to maintain a continuity of expectations Adjudication Tries to avoid unexpected outcomes Tries to support expectations that are widely and confidently held Tries to maintain a continuity of expectations The Importance of Precedents

The Economic Way of Thinking 10e ©Prentice Hall The Problem of Radical Change Technology sometimes forces rapid changes. New rules must be formed if negative externalities rapidly multiply. Rising incomes have created changes in property rights. Cost of pollution has changed.

The Economic Way of Thinking 10e ©Prentice Hall  We now place a high value on clean air.  Clean air as a right  Requires new rules The Problem of Radical Change

The Economic Way of Thinking 10e ©Prentice Hall Reducing Externalities Through Legislation The creation of new rules is called legislation.The creation of new rules is called legislation. –Legislation creates changes in prevailing property rights. –Changing the rules of the game always raises the question of fairness and compels major changes in behavior.

The Economic Way of Thinking 10e ©Prentice Hall Reducing Externalities Through Legislation The creation of new rules is called legislation.The creation of new rules is called legislation. –Legislation creates changes in prevailing property rights. –Changing the rules of the game always raises the question of fairness and compels major changes in behavior. The challenge for a society is to legislate in ways that avoid gross injustice and that minimize the cost of achieving the objectives. The challenge for a society is to legislate in ways that avoid gross injustice and that minimize the cost of achieving the objectives.

The Economic Way of Thinking 10e ©Prentice Hall Reducing Externalities Through Legislation Each contributor to negative externalities acts as if his or her own benefit exceeds in value the tiny additional cost that this act imposes on everyone in the community. The solution to this problem is to internalize those externalities through legislation.

The Economic Way of Thinking 10e ©Prentice Hall Minimizing Cost Minimizing cost isn’t the only consideration when government officials are trying to achieve some objective.Minimizing cost isn’t the only consideration when government officials are trying to achieve some objective. Fairness is also an criterion for the evaluation of government decisions.Fairness is also an criterion for the evaluation of government decisions.

The Economic Way of Thinking 10e ©Prentice Hall It is difficult at times for government agencies to determine unit cost. Polluters have an incentive to exaggerate their costs. To resolve this kind information scarcity in the least costly manner, the EPA could impose tax per unit of emissions. Another Approach: Taxing Emissions

The Economic Way of Thinking 10e ©Prentice Hall Pollution is a spillover cost, a cost not borne by its producer. Pollution is a spillover cost, a cost not borne by its producer. If the per unit cost of pollutant is set equal to the spillover cost per unit then the creator of the costs is made to bear them. If the per unit cost of pollutant is set equal to the spillover cost per unit then the creator of the costs is made to bear them. With the tax, less pollution will occur. With the tax, less pollution will occur. Question. Question. At what point would pollution cease? At what point would pollution cease? Another Approach: Taxing Emissions

The Economic Way of Thinking 10e ©Prentice Hall Another Approach: Taxing Emissions The task of the EPA is to compare the marginal cost of reducing the emissions with the marginal benefits.

The Economic Way of Thinking 10e ©Prentice Hall Licenses to Pollute? Most pollution should be viewed as a cost, not a crime. By taxing the polluters the government is providing in effect, a “license to pollute”.

The Economic Way of Thinking 10e ©Prentice Hall Efficiency and Fairness Some people object to taxes on pollutants because they regard such taxes as unfair. They supposedly place the whole burden of the tax on the poor, while allowing the rich to go on fouling the environment. It must be shown that the efficient solution can be achieved while settling the fairness issue in different ways.

The Economic Way of Thinking 10e ©Prentice Hall Efficiency and Fairness The tax approach to pollution reduction is in general reduction is in general superior to an approach that assigns physical restrictions to restrictions to particular firms.

The Economic Way of Thinking 10e ©Prentice Hall The Bubble Concept The bubble effect pretends that there is a giant “bubble” over the whole firm and control total emissions into the bubble. Under this policy firms could lower the cost of achieving a target level of air quality by allowing emissions to rise wherever their control was especially costly, and making it up where emissions could be reduced at lower cost. The bubble effect pretends that there is a giant “bubble” over the whole firm and control total emissions into the bubble. Under this policy firms could lower the cost of achieving a target level of air quality by allowing emissions to rise wherever their control was especially costly, and making it up where emissions could be reduced at lower cost.

The Economic Way of Thinking 10e ©Prentice Hall Rights and The Social Problem of Pollution  Pollution is a major social and political concern at this time because people disagree about rights.  Demand is never completely inelastic for any good, not even clean air.  Command and control should be avoided, and people should be allowed the freedom to choose the means of pollution reduction which lowers the cost to themselves.

The Economic Way of Thinking 10e ©Prentice Hall Traffic Congestion As An Externality Traffic congestion is a negative externality. It is a cost generated by people who don’t take it into account when making their decisions. They only take into account the cost other drivers create. If motorists had to pay the marginal congestion cost that their decision to drive imposed on others, as well as the cost to themselves, they would choose to drive less.

The Economic Way of Thinking 10e ©Prentice Hall Traffic Congestion As An Externality Question How can the externalities be internalized? Answer Pricing (congestion pricing) Pricing in the form of tolls for driving Gasoline cost pay the cost of constructing the roads, not using them.

The Economic Way of Thinking 10e ©Prentice Hall Spillover cost are actions that people take which impose costs on others that the actors do not take into account.Spillover cost are actions that people take which impose costs on others that the actors do not take into account. –Economist refer to these as spillover cost, or externalities. Transaction cost frequently will prevent people from negotiating more satisfactory arrangements.Transaction cost frequently will prevent people from negotiating more satisfactory arrangements. –Negotiation is used to secure cooperation. –Clearly defined property rights make negotiations easier. Once Over Lightly

The Economic Way of Thinking 10e ©Prentice Hall Once Over Lightly Some pollution reduction reduction activity is more activity is more efficient than efficient than others. others.

End of Chapter 13 Next, Chapter 14 “Markets and Government” The Economic Way of Thinking 10e ©Prentice Hall 2003