1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-1 Chapter 12 Externalities, common resources and property rights

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-2 External costs and benefits Externality External cost (negative externality) –A cost of an activity that falls on people other than those who pursue the activity. External benefit (positive externality) –A benefit of an activity received by people other than those who pursue the activity.

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-3 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.  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.

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-4 External costs and benefits –Does the honeybee keeper face the right incentives? (Part II)  If the hives are located near a school, additional hives will cause more students to get stung by the bees.  For the students, the bee hives create an external cost.  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.

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-5 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. –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.

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-6 How external costs affect resource allocation Price ($/tonne) Quantity (tonnes/year) Price ($/tonne) DD Private MC 12 000 1300 S = MC 12 000 1300 Private equilibrium Quantity (tonnes/year) 2000 8000 Social optimum 2300 XC = $1000/tonne Social MC = Private MC + XC Production without external cost Production with external cost

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-7 A good whose production generates a positive externality for consumers Price Quantity D = MB S=MC Q pvt MB PVT Without external benefits Q PVT is the social optimum Social MB = MB + 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

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-8 External costs and benefits The Coase theorem –When a market leaves cash on table there is usually a response to capture the unrealised value. Example –Will Ruth dump toxins in the river? (Part I)

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-9 External costs and benefits (cont.) –The market  Ruth’s company produces a toxic waste.  If the waste is dumped into the river, Hugh cannot fish in the river.  Should Ruth install a filter? Assume there is no communication between Ruth and Hugh.

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-10 Costs and benefits of eliminating toxic waste (part 1) $100/day$130/day $100/day$50/day With filterWithout filter Gains to Ruth Gains to Hugh 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

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-11 $100/day$130/day $100/day$50/day With filterWithout filter Gains to Ruth Gains to Hugh Assume Hugh and Ruth both have property rights on the resources they use for their activity. Hugh and Ruth can communicate at no cost. Hugh offers Ruth $40 to use the filter. Economic surplus increases by $20. Costs and benefits of eliminating toxic waste (part 2)

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-12 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. Question –Why should Hugh pay Ruth to filter out toxins that would not be there in the first place if not for Ruth’s factory? Example –Assume that by law Ruth cannot dump without Hugh’s approval. –Hugh and Ruth can negotiate without cost.

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-13 Costs and benefits of eliminating toxic waste (part 3) $100/day$150/day $100/day$70/day With filterWithout filter Gains to Ruth Gains to Hugh Economic surplus = $200 w/filter & $220 w/o filter. Hugh would gain $30 with the filter but the outcome is inefficient. Ruth pays Hugh $40 to operate without the filter. Economic surplus = $110 + $110 = $220 & both gain $10. Allowing pollution increases economic surplus.

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-14 External costs and benefits When polluters are liable –Polluter’s income is lowered. –Those injured by pollution will have higher income. 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. 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.

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-15 External costs and benefits Thinking as an economist –What is the purpose of speed limits and traffic laws? –Why do council by-laws often allow people to walk their dogs on public beaches only between sunset and sunrise? –Why do most communities have zoning laws? –Why do many governments enact laws that limit the discharge of environmental pollutants?

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-16 Putting markets to work to solve the problem of externalities Government regulators don’t always have detailed information on how costs of reducing pollution varies from one firm to another. Market-based instruments (MBIs) –Policies that use a range of market-like approaches to positively influence the behaviour of people to achieve targeted outcomes.  Price-based MBIs – taxes and subsidies  Quantity-based MBIs – pollution permits

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-17 The optimal amount of negative externalities is not zero Quantity of pollution MC/MB MC (increasing opportunity cost) Q MB = MB MB (diminishing marginal utility) Optimal amount of pollution: MC = MB

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-18 Property rights common resources and open access The problem of unowned resources –When no one owns property, the opportunity cost of using it is not considered. –Use of the property will increase until MB = 0. –Example: How many cows will villagers send onto a common grazing area?

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-19 Number of cows on the commons 112626 211919 311616 411313 511111 Price per 2-year-old cow ($) Income per cow ($/year) A village has 5 residents Each has savings = $100. Each villager can buy a bond paying 13%/year or a cow which must be sold in one year. Investment decisions are individual and public. Will there be a socially optimal outcome? The relationship between herd size and cow price Individual choice 4 cows = $52 1 bonds= $13 Total Income = $65 Act individually to maximise income

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-20 Marginal income and the socially optimal herd size 1126262626 2119193812 3116164810 411313524 511111553 Act collectively to maximise village income Socially optimal choice 1 cow = $26 4 bonds = $52 Total Income = $78 Individual choice 4 cows = $52 1 bonds = $13 Total Income = $65 Number of cows on the commons Price per 2-year-old cow ($) Income per cow ($/year) Total cattle Income ($/year) Marginal Income ($/year) Act individually to maximise income

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-21 Tragedy of commons When no one owns the commons, the opportunity cost of using it is not considered. Use of the commons will increase until MB = 0.

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-22 Property rights, common resources and open access Common resource is a resource from which it is difficult to exclude people and for which each unit consumed by one person means there is one fewer unit available for other users. One person’s use of the commons imposes an external cost on the others by making the property less valuable.

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-23 Property rights, common resources and open access (cont.) The effect of private ownership –Example  How much will the right to control the village commons sell for? –Assume  Villagers can borrow and lend at 13%.  The villagers decide to auction off the rights to the commons.  One cow is the optimal number. –Assume  Income from one cow = $26.  Pay $100 for the commons The $26 profit covers the cost of the loan to buy the cow 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

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-24 Property rights, common resources and open access (cont.) 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 cows.  Common property is not always used efficiently.

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-25 Property rights, common resources and open access (cont.) Common property –A type of property rights regime where resources are controlled by an identifiable community of users, and rules governing use are made and enforced locally. State property –A type of property regime where government has sole jurisdiction over the resource and where regulatory controls are centralised.

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-26 Property rights, common resources and open access (cont.) Private ownership may be impractical. Thinking as an economist –Why do blackberries in public parks get picked too soon? –Why are shared milkshakes consumed too quickly?

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-27 Property rights, common resources and open access When private ownership is impractical –Harvesting time on remote public land. –Harvesting whales in international waters. –Controlling multinational environmental pollution.

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-28 Positional externalities When 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. 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.

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-29 Positional externalities (cont.) Thinking as an economist –Why do professional models spend so much on cosmetic surgery?  Abigail and Stacy are competing for a single position and a $1 million contract. Positional arms race –A series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality.

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-30 Payoff matrix for cosmetic surgery Second best for each Best for Stacy Worst for Abigail Best for Abigail Worst for Stacy Third best for each No surgery Stacy Abigail Have surgery No surgery Have surgery Dominant strategy for each yields the third best outcome. Positional arms race leads to mutually offsetting investments in performance enhancement.

31. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12-31 Positional externalities Positional arms control agreements –An agreement in which contestants attempt to limit mutually offsetting investments in performance enhancements. Positional arms control agreements –Campaign spending limits –Roster limits –Arbitration agreements –Mandatory starting dates for kindergarten Social norms as positional arms control agreements –Nerd norms –Fashion norms –Norms of taste –Norms against vanity