1. MBMC Externalities and Property Rights

2. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 2 External Costs and Benefits External Cost (negative externality) A cost of an activity that falls on people other than those who pursue the activity

3. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 3 External Costs and Benefits External Benefit (positive externality) A benefit of an activity received by people other than those who pursue the activity

4. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 4 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.

5. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 5 External Costs and Benefits 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.

6. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 6 External Costs and Benefits How Externalities Affect Resource Allocation Does the honeybee keeper face the right incentives? (Part I)  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.

7. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 7 External Costs and Benefits 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.

8. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 8 External Costs and Benefits How Externalities Affect Resource Allocation Does the honeybee keeper face the right incentives? (Part II)  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.

9. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 9 External Costs and Benefits 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.

10. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 10 External Costs and Benefits How Externalities Affect Resource Allocation When an activity generates a negative externality, the level of the activity will be greater than the socially optimal level.

11. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 11 External Costs and Benefits How Externalities Affect Resource Allocation When an activity generates a positive externality, the level of the activity will be less than the socially optimal level.

12. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 12 How External Costs Affect Resource Allocation Price ($/ton) Quantity (tons/year) Price ($/ton) Quantity (tons/year) Production without external cost Production with external cost DD Private MC 12,000 1,300 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

13. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 13 A Good Whose Production Generates a Positive Externality for Consumers Price Quantity Social demand = Private Demand + XB XB MB SOC MB PVT + XB Q SOC With external benefits the private D < social D and the private optimum is less than the social optimum Deadweight loss from positive externality Private Demand MC Q pvt MB PVT Without external benefits Q PVT is the social optimum

14. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 14 External Costs and Benefits The Coase Theorem When a market leaves cash on table there is usually a response to capture the unrealized value.

15. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 15 External Costs and Benefits Example Will Abercrombie dump toxins in the river (Part I)

16. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 16 External Costs and Benefits Example The Market  Abercrombie’s company produces a toxic waste.  If the waste is dumped into the river, Fitch cannot fish the river.  Should Abercrombie install a filter? oAssume there is no communication between Abercrombie and Fitch

17. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 17 Costs and Benefits of Eliminating Toxic Waste (Part 1) $100/day$130/day $100/day$50/day With filterWithout filter Gains to Abercrombie 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

18. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 18 $100/day$130/day $100/day$50/day With filterWithout filter Gains to Abercrombie 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 (Part 2)

19. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 19 External Costs and Benefits 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.

20. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 20 External Costs and Benefits Question Why should Fitch pay Abercrombie to filter out toxins that would not be there in the first place if not for Abercrombie’s factory?

21. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 21 External Costs and Benefits Example By law Abercrombie cannot dump without Fitch’s approval. Fitch and Abercrombie can negotiate without cost.

22. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 22 Costs and Benefits of Eliminating Toxic Waste (Part 3) $100/day$150/day $100/day$70/day With filterWithout filter Gains to Abercrombie 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

23. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 23 External Costs and Benefits When polluters are liable: Polluter’s income is lowered. Those injured by pollution will have higher income.

24. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 24 The Gain in Surplus from Shared Living Arrangements Least costly ProblemAnn’s cost ofBetty’s cost ofsolution to solving problem solving problemthe problem Total cost of separate apartments (2)($400/month)$600/month$200/month = $800/month Total cost of shared apartment Rent savings From sharing Benefits of Shared Living Costs of Shared Living Ann’s phone usageCurtailedTolerate phoneBetty tolerates phone usage:usage: $150/mo.Ann’s phone usage: $250/mo.$150/mo. Gain in Surplus from Shared Living Rent savingsLeast costly accommodationGain in surplus ($200/month)to shared living problems$50/month ($150/month) Will Ann and Betty Share an apartment?

25. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 25 The Gain in Surplus from Shared Living Arrangements Least costly ProblemAnn’s cost ofBetty’s cost ofsolution to solving problem solving problemthe problem Total cost of separate apartments (2)($400/month)$600/month$200/month = $800/month Total cost of shared apartment Rent savings From sharing Benefits of Shared Living Costs of Shared Living Ann’s phone usageCurtailedTolerate phoneBetty tolerates phone usage:usage: $150/mo.Ann’s phone usage: $250/mo.$150/mo. Gain in Surplus from Shared Living Rent savingsLeast costly accommodationGain in surplus ($200/month)to shared living problems$50/month ($150/month) How much should Ann and Betty pay if they agree to split their economic surplus equally?

26. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 26 External Costs and Benefits 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.

27. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 27 External Costs and Benefits Legal Remedies for Externalities 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.

28. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 28 Legal Remedies for Externalities Economic Naturalist What is the purpose of speed limits and traffic laws?

29. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 29 Economic Naturalist Why do most communities have zoning laws? Legal Remedies for Externalities

30. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 30 Economic Naturalist Why do many governments enact laws that limit the discharge of environmental pollutants? Legal Remedies for Externalities

31. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 31 Economic Naturalist What is the purpose of free speech laws? Legal Remedies for Externalities

32. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 32 Economic Naturalist Why does government subsidize the planting of trees on hillsides? Legal Remedies for Externalities

33. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 33 The Optimal Amount of Negative Externalities is Not Zero Quantity of Pollution MC/MB MC (increasing opportunity cost) Q MC = MB MB (diminishing marginal utility) Optimal amount of pollution: MC = MB

34. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 34 Taxing a Negative Externality Price ($/ton) Quantity (tons/year) Price ($/ton) Quantity (tons/year) DD Private MC 1,300 Private MC 12,000 1,300 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 2,000 2,300 8,000 Social optimum 12,000 Private equilibrium Private equilibrium with pollution tax

35. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 35 Subsidizing a Positive Externality Price ($/ton) Quantity (tons/year) Private demand Social demand = Private demand + XB 8 Private equilibrium without subsidy MC 10 14 1,2001,600 Social optimum XB = 6 Private demand MC Private equilibrium with subsidy Subsidy = 6 1,2001,600 Subsidized demand = Private demand + tax 8 10 14

36. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 36 The Problem of Unpriced Resources When no one owns property, the opportunity cost of using it is not considered. Use of the property will increase until MB = 0. Property Rights and the Tragedy of Commons

37. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 37 Number of steers on the commons 112626 211919 311616 411313 511111 Price per 2-year-old steer ($) Income per steer ($/year) A village has: 5 residents Each has savings = $100 Each villager can buy a bond paying 13%/yr or a steer and sell it in a year Investment decisions are individual and public Will there be a socially optimal outcome? The Relationship Between Herd Size and Steer Price Individual choice 4 steers = $52 1 bonds = $13 Total Income = $65 Act individually to maximize income

38. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 38 Marginal Income and the Socially Optimal Herd Size 1126262626 2119193812 3116164810 411313524 511111553 Act collectively to maximize village income Socially optimal choice 1 steer = $26 4 bonds = $52 Total Income = $78 Individual choice 4 steers = $52 1 bonds = $13 Total Income = $65 Number of steers on the commons Price per 2-year-old steer ($) Income per steer ($/year) Total cattle Income ($/year) Marginal Income ($/year) Act individually to maximize income

39. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 39 Property Rights and the Tragedy of Commons The Problem of Unpriced 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.

40. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 40 Property Rights and the Tragedy of Commons The Effect of Private Ownership Example  How much will the right to control the village commons sell for?

41. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 41 Property Rights and the Tragedy of Commons 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

42. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 42 Property Rights and the Tragedy of Commons The Effect of Private Ownership Assume  Income from one steer = $26.  Pay $100 for the commons oThe $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: o(4 x $13) + $26 = $78 or o(4 x $13) + $13 rent + $13 highest bidder = $78

43. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 43 Property Rights and the Tragedy of Commons The Effect of Private Ownership Observations  When the land is auctioned, the highest bidder will have an incentive to consider the opportunity cost of grazing additional steers.  Common property is not used efficiently.

44. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 44 Property Rights and the Tragedy of Commons The Effect of Private Ownership Observations  Zoning laws and other regulations restrict the use of private property.  The laws can be used to maximize economic surplus.

45. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 45 Property Rights and the Tragedy of Commons The Effect of Private Ownership Observations  The laws can also be used to achieve an individual goal (reelection) by reducing the economic surplus.  Private ownership may be impractical.

46. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 46 Property Rights and the Tragedy of Commons Economic Naturalist Why do blackberries in public parks get picked too soon? Why are shared milkshakes consumed too quickly?

47. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 47 Property Rights and the Tragedy of Commons When Private Ownership is Impractical Harvesting timber on remote public land Harvesting whales in international waters Controlling multinational environmental pollution

48. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 48 Positional Externalities Payoffs That 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.

49. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 49 Positional Externalities Payoffs That Depend on Relative Performance In a competitive situation:  When the payoff depends on relative performance, incentive to invest in performance activities will be excessive from a collective point of view.

50. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 50 Positional Externalities Economic Naturalist Why do football players take anabolic steroids?  Smith and Jones are competing for a single position and a $1 million contract.

51. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 51 Payoff Matrix for Steroid Consumption Second best for each Best for Jones Worst for Smith Best for Smith Worst for Jones Third best for each Don’t take steroids Jones Smith Take steroids Don’t take steroids 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.

52. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 52 Positional Arms Races and Positional Arms Control Agreements 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

53. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 53 Positional Arms Races and Positional Arms Control Agreements Positional Arms Race A series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality

54. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 54 Positional Arms Control Agreements An agreement in which contestants attempt to limit mutually offsetting investments in performance enhancements Positional Arms Races and Positional Arms Control Agreements

55. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 55 Positional Arms Control Agreements Campaign spending limits Roster limits Arbitration agreements Mandatory starting dates for kindergarten Positional Arms Races and Positional Arms Control Agreements

56. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12: Externalities and Property Rights Slide 56 Social Norms as Positional Arms Control Agreements Nerd norms Fashion norms Norms of taste Norms against vanity Positional Arms Races and Positional Arms Control Agreements

57. MBMC End of Chapter End of Chapter