1. 14-1 Economics: Theory Through Applications

2. 14-2 This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA

3. 14-3 Chapter 14 Cleaning Up the Air and Using Up the Oil

4. 14-4 Learning Objectives What is the Coase theorem? Why is the Coase theorem important? What is a social dilemma? What is an externality? What are the ways in which problems caused by externalities can be solved?

5. Learning Objectives What are some of the difficulties in designing policies to deal with externalities? What is the Hotelling rule for the use of resources? What is a non-excludable good? What is an accumulable resource? 14-5

6. Figure 14.1 - The 30 Most Polluted Cities in the World 14-6

7. Figure 14.2 - The Gains from Trade 14-7

8. Mixed Messages 14-8

9. Table 14.1 - The Payoffs in a Social Dilemma Game 14-9

10. Figure 14.3 - A Divergence between Marginal Private Cost and Marginal Social Cost 14-10

11. Figure 14.4 - A Divergence between Marginal Private Benefit and Marginal Social Benefit 14-11

12. The Hotelling Rule 14-12

13. Figure 14.5 - The Price of Oil (in 2008 Dollars) 14-13

14. Key Terms Buyer’s surplus: A measure of how much the buyer gains from a transaction that is equal to the buyer’s valuation minus the price Seller’s surplus: A measure of how much the seller gains from a transaction that is equal to the price minus the seller’s valuation Property rights: An individual’s (or institution’s) legal right to make all decisions regarding the use of a particular resource Transaction costs: The costs of making and enforcing agreements 14-14

15. Key Terms Coase theorem: If property rights are clearly established and transaction costs are low, private bargaining will lead to efficient outcomes Social dilemma: A situation where individually rational choices lead to an outcome that is bad for society as a whole Marginal valuation: The maximum amount an individual would be willing to pay to obtain one extra unit of that good Marginal cost: The extra cost of producing an additional unit of output, which is equal to the change in cost divided by the change in quantity 14-15

16. Key Terms Marginal social cost: The cost to society of consuming or producing one more unit of a good or a service Externality: The direct cost imposed or direct benefit bestowed by one person’s actions on others in society Negative externality: The direct cost imposed by one person’s actions on others in society Positive externality: The direct benefit bestowed by one person’s actions on others in society 14-16

17. Key Terms Marginal social benefit: The benefit to society of consuming or producing one more unit of a good or service Tradable emission permit: A license to emit a specified amount of pollution Command and control: Regulation in which there are mandates for maximum permissible levels of pollution Contingent valuation: The techniques used for eliciting the values that individuals place on goods and services that are not bought and sold in the marketplace 14-17

18. Key Terms Risk averse: Being willing to pay more than a gamble’s expected loss in order to avoid that gamble Nonrenewable (exhaustible) resource: A resource that does not regenerate over time Hotelling rule: An arbitrage condition for the use of resource stocks Arbitrage: The act of buying and then selling an asset to make a profit Nominal interest factor: A factor, equal to 1 + nominal interest rate, used to convert dollars today into dollars next year 14-18

19. Key Terms Non-excludable: A good (or resource) for which it is impossible to selectively deny access Excludable: A good (or resource) that we can selectively allow or deny access Renewable resource: A resource that regenerates over time Accumulable resource: A resource that can be increased without limit over time through investment Human capital: The skills and knowledge that are embodied within workers 14-19

20. Key Takeaways The Coase theorem states that if property rights are well defined and transactions costs are low, then bargaining will lead to an efficient outcome The Coase theorem provides the rationale for a market solution to pollution and other similar social problems A social dilemma arises when there are many individuals each making choices that are in their self-interest but leading to an outcome that is bad for society 14-20

21. Key Takeaways An externality arises when an action taken by one person directly affects another’s welfare – These operate outside of markets One solution to an externality problem is to create a market so that the affects of one person’s actions on others will be reflected in the market price of taking that action – Another solution is to put in place taxes or subsidies so that private incentives are aligned with social goals 14-21

22. Key Takeaways One challenge for policy design is that the valuation of environmental goods is difficult to measure – Moreover, external effects do not respect borders, so international agreements are often required According to the Hotelling rule, a resource should be extracted so that the rate of price increase in the resource should be the same as the interest rate 14-22

23. Key Takeaways A good is nonexcludable if it is impossible to deny access to it An accumulable resource is one that can be increased over time with investment – Leading examples include physical capital and human capital 14-23