Chapter11ExternalitiesandPropertyRightsLearningObjectivesDefinenegativeandpositiveexternalitiesandanalyzetheireffectonresourceallocationsExplainhowtheeffectsofexternalitiescanberemediedDiscusswhytheoptimalamountofanexternalityisnotzeroCharacterizethetragedyofthecommonsandshowhowprivateownershipisawayofpreventingitDefinepositionalexternalitiesandtheireffectsShowhowtheycanberemediedExternalCostsandBenefitsExternalcostisacostofanactivitythatispaidbypeopleotherthanthosewhopursuetheactivityAlsocalledanegativeexternalityExternalbenefitisabenefitofanactivityreceivedbyathirdpartyAlsocalledapositiveexternalityExternalitiesAffectResourceAllocationExternalitiesreduceeconomicefficiencySolutionstoexternalitiesmaybeefficientWhenefficientsolutionstoexternalitiesarenotpossible,governmentinterventionorothercollectiveactionmaybeusedHoneybeeKeeper–Scenario1PhoebeharvestsandsellshoneyfromherbeesBeespollinatetheappleorchardsNopaymentsmadetoPhoebeThebeesprovideafreeservicetothelocalfarmersPhoebeisgivingawayaservicePrivatecostsareequaltoprivatebenefitsSocialcostsarelessthansocialbenefitsWhenexternalbenefitsexist,

maximizingprivateprofitsproducesless

thanthesocialoptimumHoneybeeKeeper–Scenario2PhoebeharvestsandsellshoneyfromherbeesNeighboringschoolandnursinghomesarebotheredbybeestingsThebeesareanuisancetotheneighborsPhoebeisnotpayingallthecostsofherhoneybeesPrivatecostsareequaltoprivatebenefitsSocialcostsaregreaterthansocialbenefitsWhenexternalcostsexist,

maximizingprivateprofitsproducesmore

thanthesocialoptimumExternalCostQuantity(tons/year)12,0001.3Price($000s/ton)DPrivateMC$1,000/tonExternalCostsPrice($000s/ton)NoExternalCostQuantity(tons/year)12,0001.3DPrivateMCPrivateEquilibriumDeadweightlossfrompollution=$2M/yrSocialOptimum2.3SocialMC2.08,000PositiveExternalityforConsumersDeadweightlossfrompositiveexternalityXBMBPVT+XBSocialDemandMBSOCQSOCPriceQuantityPrivateDemandMCQPVTMBPVTPrivateEquilibriumSocialOptimumEffectsofExternalitiesWithexternalities,

privatemarketoutcomes

donotachieve

thelargestpossibleeconomicsurplusCashisleftonthetableRemedyingExternalitiesWithexternalities,privatemarketoutcomesdonotachievethelargestpossibleeconomicsurplusCashisleftonthetableForexample,withmonopolies,outputislowerthanwithprefectcompetitionIntroductionofcouponsandrebatesexpandsthemarketWithexternalities,actionstocapturethesurplusarelikelyAbercrombiethePolluter–Scenario1Abercrombie’scompanydumpstoxicwasteintheriverFitchcannotfishtheriverNooneelseisharmedAbercrombiecouldinstallafiltertoremovetheharmtoFitchFilterimposescostsonAbercrombieFilterbenefitsFitchPartiesdonotcommunicateAbercrombie'sFilterOptionsWithFilterWithoutFilterAbercrombie'sGains$100/day$130/dayFitch'sGains$100/day$50/dayTotalGains$200/day$180/dayAbercrombiedoesnotinstallthefilterMarginalcostoffiltertoAbercrombieis$30perdayThemarginalbenefittoFitchis$50perdayThereisanetwelfarelossof$20perdayAbercrombiethePolluter–Scenario2CommunicationschangestheoutcomeFitchpaysAbercrombiebetween$30and$50perdaytousethefilterNetgainintotalsurplusof$20perdayWithFilterWithoutFilterAbercrombie'sGains$100/day$130/dayFitch'sGains$100/day$50/dayTotalGains$200/day$180/dayTheCoaseTheoremIfpeoplecannegotiatetherighttoperformactivitiesthatcauseexternalities,theycanalwaysarriveatefficientsolutionstoproblemscausedbyexternalitiesNegotiationsmustbecostlessSometimesthoseharmedpaytostoppollutionThecaseofAbercrombieandFitchSometimespolluterbuystherighttopolluteAbercrombiepaysFitchifthevalueofpollutingisgreaterthantheharmtoFitchTheadjustmenttotheexternalityisusuallydonebythepartywiththelowestcostAbercrombiethePolluter–Scenario3Abercrombie’scompanyproducestoxicwasteLawsprohibitdumpingthewasteintheriverUNLESSFitchagreesNewgainsmatrixWithFilterWithoutFilterAbercrombie'sGains$100/day$150/dayFitch'sGains$100/day$70/dayTotalGains$200/day$220/dayAbercrombiethePolluter–Scenario3AbercrombiecanpayFitchupto$50perdayfortherighttopolluteFitchwillacceptanyofferover$30perdayInthisscenario,pollutingistherightthingtodoWithFilterWithoutFilterAbercrombie'sGains$100/day$150/dayFitch'sGains$100/day$70/dayTotalGains$200/day$220/dayLawsCanChangetheOutcomeSupposethelawmakespollutersliableforthecostofcleaninguptheirpollutionPollutersgetlowerincomesNon-pollutersgethigherincomesWithFilterWithoutFilterAbercrombie'sGains$100/day$150/dayFitch'sGains$100/day$70/dayTotalGains$200/day$220/daySharedLivingAnnandBettyareevaluatinghousingoptions2-bedroomapartmentfor$600permonthOR21-bedroomapartmentsfor$400permontheachIfthecostswerethesame,AnnandBettywouldbeindifferentbetweenthetwoarrangementsTheexternalityhereisAnn'stelephoneusageishighShewouldpayupto$250permonthtobeabletousethephonewhenevershewantsBettywouldpayupto$150permonthtogetbetterphoneaccessNosecondphonelineispossibleBenefitsandCostsofSharedLivingTotalCostofSeparateApartmentsTotalCostofSharedApartmentRentSavingsfromSharing$800permonth$600permonth$200permonthLivetogetherifthebenefitsexceedthecostsProblemAnn'sCostofSolvingtheProblemBetty'sCostofSolvingtheProblemLeast-CostSolutionAnn'sphoneusagePayAnn$250todecreaseusagePayBetty$150totolerateAnnAnnpaysBetty$150permonthNetBenefitofSharedLiving$200permonth$150permonth$50permonthAnnandBettywilllivetogetherRentSavingsCostofPhoneAccommodationGaininSurplusDividingtheRentBettywouldspend$400permonthtolivealoneThecostoftoleratingAnn'sphoneuseis$150permonthBettywillbewillingtopayupto$250=$400-$150tolivewithAnnAbove$250,shewillbebetterofflivingaloneAnniswillingtopayupto$400permonth,thecostoflivingaloneDividingtheSurplusBetty'smaximumrentis$250Ann'smaximumrentis$400Iftheydividethesurplus($50)equally,Bettypays$225=$250–$25Annpays$375=$400–$25WhenAreLegalRemediesforExternalitiesNeeded?Ifnegotiationiscostless,thepartywiththelowestcostusuallymakestheadjustmentPrivatesolutionisgenerallyadequateWhennegotiationisnotcostlesslawsmaybeusedtocorrectforexternalitiesTheburdenofthelawcanbeplacedonthosewhohavethelowestcostExamplesofLegalRemediesforExternalitiesNoiseregulations(cars,parties,honkinghorns)Mosttrafficandtraffic-relatedlawsCaremissionstandardsandinspectionsZoninglawsBuildingheightandfootprintregulations(sunshinelaws)AirandwaterpollutionlawsThreeCasesFreeSpeechFirstAmendmentrecognizesthevalueofopencommunicationsHardtoidentifyspeechthathasanetcostSomelimitationsYelling"fire"inacrowdedtheatrePromotetheviolentoverthrowofthegovernmentPlantingTreesGovernmentsubsidizestreesonprivatepropertyDecreaseschancesoffloodingandlandslidesNetreductionofCO2intheatmosphereBasicResearchMillionsofdollarsspentbyfederalgovernmentyearlyExternalitiesofnewknowledgeOptimalAmountofNegativeExternalitiesQuantityofPollutionMC&MBMCQMC

=MBMBOptimalamountofpollutionQuantity(tons/year)Price($000s/ton)DPrivateMC12,0001.3PollutionTax

$1,000/tonTaxingaNegativeExternalityTaxPrivateMC+Tax2.32.08,0002.08,000PrivateEquilibriumSocialOptimumAfterTaxEquilibriumBeforeTaxEquilibriumSocialMCXCQuantity(tons/year)Price($000s/ton)DPrivateMC1.312,000NoPollutionTaxSubsidizingaPositiveExternality12Quantity

(000stons/year)Price($/ton)PrivateDemandMC8NoSubsidy141016Quantity

(000stons/year)Price($/ton)SubsidyPrivateDemandMC128141016XBSocialDemandSubsidizedDemandSubsidyTragedyofCommonsWhenuseofacommunallyownedresourcehasnoprice,thecostsofusingitarenotconsideredUseofthepropertywillincreaseuntilMB=0Suppose5villagersownlandsuitableforgrazingEachcanspend$100foreitherasteeroragovernmentbondthatpays13%VillagersmakesequentialdecisionsTheyknowwhateveryonebeforethemhasdoneSteersgrazeonthecommonsValueofthesteerinyear2dependsonherdsizePayoffForaSteerUsingtheinformationinthetablebelow,eachvillagermakesadecisionThefourthisindifferentbetweenthetwoassetsHebuysasteerThefifthbuysabond#SteersSellingPriceperSteerIncomeperSteer112626211919311616411313511111WhattheVillagersDidThevillagehas4steersfeedingonthecommonsforoneyearAttheendoftheyear,4steerssellfor$113eachTotalrevenueforthevillageis(5)(113)=$565Outcomeisthesameas5bondsTheycouldhavedonebetterABetterChoice#SteersSellingPriceIncomepersteerTotalCattleIncomeMarginalIncome112626262621191938123116164810Netincomefromonebondafteroneyearis$13Buyasteeronlyifitsmarginalbenefitisatleast$13FirstvillagerbuysasteerandallothersbuybondsTotalnetincomeis26+(4)(13)=$78Anetgainof$13comparedtothefirstscenarioTragedyofthecommonsisthetendencyforaresourcethathasnopricetobeuseduntilitsmarginalbenefitiszeroTheEffectofPrivateOwnershipThevillagersdecidetoauctionofftherightstothecommonsAuctionmakesthehighestbidderconsidertheopportunitycostofgrazingadditionalsteersVillagerscanborrowandlendat13%.OnesteeristheoptimalnumberWinningbidderpays$100fortherighttousethecommonsTheEffectofPrivateOwnershipThewinningbidderstartstheyearSpends$100insavingstobuyayearlingsteerBorrows$100at13%togetcontrolofcommonsThewinningbidderendstheyearSellsthesteerfor$126Getsoriginal$100back$13opportunitycostofbuyingasteer$13interestonloanforthecommonsEconomicsurplusofthevillageis(4x$13)+$26=$78PropertyRightsandtheTragedyofCommonsBlackberriesintheParkSweetnessincreasesastheberryripensBlackberriesarecommonpropertyBerrieswillbeeatenbeforetheyarefullyripeOtherExamplesHarvestingTimberonremotepubliclandWhalesinopenoceansWorldwidepollutionSharedMilkshakesMilkshakeschilltastebudsDecreaseappreciationofitsflavorDrinkingslowlyincreasesappreciationIftwopeoplesharethemilkshake,itisacommongoodTheywilldrinkfasterthanifitwereaprivategoodPositionalExternalitiesHighestcompensationgoestothebestperformerStandardisalsorelative,notonlyabsoluteEachplayerincreasesspendingtoincreaseprobabilityofwinningSumofalltheseinvestments>collectivepayoffTotalpayout