1. Agenda for 12th Class Efficiency Externalities
Assignment for Next Class
##56-58
Question to think about / Writing assignment for Group 1
Q 1 on p. 237

2. Review I
Cost-Benefit analysis needs to take into account costs and benefits that are not usually expressed in monetary terms
Life, health, pollution, dead plankton
Methods
Surveys
Observation of market effects

3. Review Derek & Amartya Cost-Benefit analysis and utilitarianism
Usually cost-benefit analysis leads to greater happiness
But not always
That is point of Derek-Amartya example
If Amartya pays Derek $2.50 for book, then happiness increases
Derek gets $2.50 which values more than book and can buy medicine
Amartya gets book which he values more than $2.50
Also passes cost-benefit analysis
Net benefit of $0.50 to Derek: Gets $2.50, loses book worth $2 to him
Net benefit of $0.50 to Amart.: Gets book worth $3 to him, pays $2.50
Social net benefit of $1
If tyrant takes book from Derek and gives it to Amartya
No payment, just forced transfer
Happiness does NOT increase
Derek loses book that loves and does not get medicine
Amartya gets book that doesn’t care much about
But still passes cost-benefit analysis
Net loss of $2 to Derek (value of book to him)
Net benefit of $3 to Amartya (value of book to him)
Problem is that money does not bring same amount of happiness to D & A

4. Redistribution of Income
Utilitarian can justify because of declining marginal utility of money
Taking $1 (or $1000) from rich person and giving it to poor person is likely to increase happiness in society
Although must take into account cost of taking money
Cost of running tax system
Disincentive for rich person to earn and save
Rights based arguments for redistribution (Rawls)
Equality is basic principle of justice, and economic inequality can only be justified to the extent that it is necessary to encourage people to work and generate income in the first place.
People don’t deserve their income, because income largely attributable to genes and childhood environment, which people get from parents
Techniques for redistribution
Progressive Taxes
Social programs: Social security, welfare (TANF), Medicaid, Medicare, Food Stamps
Lawsuits: Very inefficient way of redistribution
Very few actually benefit
Lawyers get half (and they are not usually poor)
Costs often passed back to consumers in higher prices
May distort incentives to take precautions, perform/breach contracts

5. Questions
2) People around the world (and even in the United States) die every day because they cannot afford relatively inexpensive medical treatments that would keep them alive. Is it immoral for people to take vacations or buy iPods and nice clothes when the money could be contributed to charities (such as Doctors Without Borders) that would use the money to save lives?
3) Are you convinced by the utilitarian or rights–based arguments for the redistribution of income? If not, do you think redistribution of income is unjust? Do you think there are better arguments for the redistribution of income?

6. Efficiency I Efficiency
Pareto. Situation is Pareto superior if it makes at least one person better off and no one worse off
Situation is Pareto optimal or efficient, if there is no situation which is Pareto superior to it
Problems
Very few legal changes make no one worse off
Ignores distribution
Situation in which I have all the wealth is efficient

7. Efficiency II Kaldor-Hicks Efficiency Wealth-maximization
Situation is Kaldor-Hicks superior if winners can compensate losers and still be better off
Situation is Kaldor Hicks optimal or efficient, if there is no situation which is Kaldor-Hicks superior to it
Roughly equivalent to cost-benefit analysis, where costs & benefits judged by willingness to pay
Problems. Willingness to pay is not always ethically attractive criterion
Wealth-maximization
Posner calls use of Kaldor-Hicks efficiency to choose among legal rules “wealth maximization”
Confusing, because “wealth” usually refers to things like stock, bonds, jewels, and real estate
But selling stock to go on vacation can be “wealth maximizing,” if person values vacation more than stock

8. C D A B
B’s well-being
A’s well-being

9. Competitive Markets and Efficiency
In general
Competitive markets are
Pareto efficient
Kaldor-Hicks efficient
Maximize sum of producer and consumer surplus
Where surplus is measured
For producers as difference between cost and price
For consumers as difference between subjective benefit and price
Any deviation from competitive price
Harms someone (so not Pareto superior)
Blocks mutually beneficial transaction
Artificially low price blocks transaction between higher cost seller and high value buyer
Analysis assumes
No externalities
Perfect information
No transactions costs
Benefits measured by willingness to pay

10. Externalities Externalities are ubiquitous Negative externalities
Pollution
All torts: trespass, negligence, product liability, medical malpractice, etc.
Traffic
Playing loud music
Being mean to friends or strangers
Positive Externalities
Volunteer work
Rescuing friend or stranger
Running an organization well
Voting (governmental or corporate)
Being green

11. Policy Responses to Negative Externalities
“Internalize” externalities
Make it in the self-interest of the person imposing externality to do the right thing
Impose liability equal to harm
Most of tort law
Impose corrective taxes equal to harm
Carbon tax
Congestion tax
Cigarette taxes?
Cap & trade is, in effect, tax
b/c emitters will have to pay for permits (or forgo revenue which could have received for selling them)
Impose Criminal Penalties
Most crimes impose externalities
Murder, robbery, theft
Query re “victimless crimes,” such as drugs and prostitution
Regulate
Set maximum automobile emissions
Require “best available technology” for electric power plants
Set capital requirements for banks

12. Questions on Externalities
4. Review the statutes at issue in the cases we have read so far—the sentence enhancement statute in Smith, Title VII in Weber, and The Sherman Antitrust Act in National Society. Do they address externalities?
Were there externalities in Union Pacific v Jones?
If so, what rule would cause the railroad to internalize those externalities?
From an economic point of view, what would the best legal rule be regarding the duty to rescue?

13. Externalities & Coase Theorem
When externalities affect small number of people who can negotiate ex ante or who deal with each other repeatedly, probably don’t need law to correct or encourage
Nice or mean things done to family or friends
Contracts usually deal explicitly with externalities
E.g. promisee pays for positive externality granted by promisor
Parties indemnify each other for harm
But law sometimes imposes mandatory terms
E.g. Product liability, medical malpractice liability
Covenants running with land, homeowners associations
Deal with externalities among neighbors
But when externalities affect large numbers of people, need law
Pollution, congestion, torts among strangers, etc.

14. Prisoners’ Dilemma Dominant Strategy. Nash Equilibrium
Suspect 2
Confess
Keep quiet
Suspect 1
-5, -5
-1, -7
Keep Quiet
-7, -1
-2. -2
Dominant Strategy. Nash Equilibrium
Each suspect imposes negative externalities on the other
Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

15. Pollution Externalities Game
Firm 2
Pollute
Install
Firm 1
-4000, -4000
-2000, -5000
-5000, -2000
Almost identical to Prisoners’ dilemma
If numbers small, might expect agreement to install pollution control
When numbers large, negotiation very difficult
Collective action problem
Everyone better off if everyone installs pollution control equipment
But each person better off if free rides
Better to not install pollution control equipment, if everyone else does

16. Collective Action Problems
Collective Action Problems are ubiquitous
Becoming informed voter, voting
Funding public goods, e.g. fire departments, bridges, national defense
Global warming
Fishing
Every collective action problem is also an externalities problem
Sometimes groups can resolve
Political lobbying by interest groups
Democracy
Voluntary organizations
Clubs
Often government is only or best solution