1. Externalities and Property Rights
Chapter 12
Externalities
and Property Rights

2. 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

3. 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

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

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

6. 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

7. 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

8. 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.

9. 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.

10. How External Costs Affect Resource Allocation

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

12. 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

13. 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.

14. 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

15. 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.

16. 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

17. 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

18. 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

19. 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.

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

21. 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.

22. Taxing a Negative Externality
Figure 12.3, P.322

23. Socially optimal pollution:
Not necessarily zero

24. Why a Market Economy Produces Too Much Pollution

25. 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

26. 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)
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

27. 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.

28. 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

29. 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.

30. 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

31. 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.