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Chapter 11: Externalities and Property Rights Slide 2
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
External Cost (negative externality)A cost of an activity that falls on people
other than those who pursue the activity
Chapter 11: Externalities and Property Rights Slide 3
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
External Benefit (positive externality)A benefit of an activity received by people
other than those who pursue the activity
Chapter 11: Externalities and Property Rights Slide 4
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Externalities reduce economic efficiency.
Solutions of externalities may be efficient.
Chapter 11: Externalities and Property Rights Slide 5
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
When efficient solutions to externalities are not possible, government intervention or other collective action may be used.
Chapter 11: Externalities and Property Rights Slide 6
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
How Externalities Affect Resource AllocationDoes 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.
Chapter 11: Externalities and Property Rights Slide 7
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
How Externalities Affect Resource AllocationDoes 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.
Chapter 11: Externalities and Property Rights Slide 8
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
How Externalities Affect Resource AllocationDoes 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.
Chapter 11: Externalities and Property Rights Slide 9
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
How Externalities Affect Resource AllocationDoes 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.
Chapter 11: Externalities and Property Rights Slide 10
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
How Externalities Affect Resource AllocationWhen 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.
Chapter 11: Externalities and Property Rights Slide 11
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
How Externalities Affect Resource AllocationWhen an activity generates a negative
externality, the level of the activity will be greater than the socially optimal level.
Chapter 11: Externalities and Property Rights Slide 12
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
How Externalities Affect Resource AllocationWhen an activity generates a positive
externality, the level of the activity will be less than the socially optimal level.
Chapter 11: Externalities and Property Rights Slide 13
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
How External Costs Affect Resource Allocation
Pri
ce (
$/to
n)
Quantity (tons/year)
Pri
ce (
$/to
n)
DD
Private MC
12,000
1,300Private MCwith pollution
12,000
1,300
Privateequilibrium
Quantity (tons/year)
2,000
8,000Social
optimum
2,300XC = Pollution cost = $1,000/ton
Social MC =Private MC + XC
Production without external cost Production with external cost
Chapter 11: Externalities and Property Rights Slide 14
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
A Good Whose Production Generates a Positive Externality for Consumers
Pri
ce
Quantity
Private Demand
MC
Qpvt
MBPVT
• Without external benefits QPVT is the social optimum
Social demand = Private Demand + XB
XB
MBSOC
MBPVT + XB
QSOC
• With external benefits the private D < social D and the private optimum is less than the social optimum
Chapter 11: Externalities and Property Rights Slide 15
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
The Coase TheoremWhen a market leaves cash on table there
is usually a response to capture the unrealized value.
Chapter 11: Externalities and Property Rights Slide 16
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
ExampleWill Abercrombie dump toxins in the river
(Part I)
Chapter 11: Externalities and Property Rights Slide 17
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
ExampleThe 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?o Assume there is no communication between
Abercrombie and Fitch
Chapter 11: Externalities and Property Rights Slide 18
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Costs and Benefits of Eliminating Toxic Waste (Part 1)
$100/day $130/day
$100/day $50/day
With filter Without filter
Gains toAbercrombie
Gains toFitch
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
Chapter 11: Externalities and Property Rights Slide 19
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
$100/day $130/day
$100/day $50/day
With filter Without filter
Gains toAbercrombie
Gains toFitch
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 1)
Chapter 11: Externalities and Property Rights Slide 20
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
The Coase TheoremIf 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.
Chapter 11: Externalities and Property Rights Slide 21
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
QuestionWhy should Fitch pay Abercrombie to filter
out toxins that would not be there in the first place if not for Abercrombie’s factory?
Chapter 11: Externalities and Property Rights Slide 22
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
ExampleBy law Abercrombie cannot dump without
Fitch’s approval.Fitch and Abercrombie can negotiate
without cost.
Chapter 11: Externalities and Property Rights Slide 23
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Costs and Benefits of Eliminating Toxic Waste (Part 3)
$100/day $150/day
$100/day $70/day
With filter Without filter
Gains toAbercrombie
Gains toFitch
•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
Chapter 11: Externalities and Property Rights Slide 24
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
When polluters are liable:Polluter’s income is lowered.Those injured by pollution will have higher
income.
Chapter 11: Externalities and Property Rights Slide 25
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Gain in Surplus from Shared Living Arrangements
Least costlyProblem Ann’s cost of Betty’s cost of solution to
solving problem solving problem the problem
Total cost ofseparate apartments
(2)($400/month) $600/month $200/month= $800/month
Total cost ofshared apartment
Rent savings From sharing
Benefits of Shared Living
Costs of Shared Living
Ann’s phone usage Curtailed Tolerate phone Betty toleratesphone usage: usage: $150/mo. Ann’s phone
usage: $250/mo. $150/mo.
Gain in Surplus from Shared Living
Rent savings Least costly accommodation Gain in surplus($200/month) to shared living problems $50/month
($150/month)
Will Ann and Betty Share an apartment?
Chapter 11: Externalities and Property Rights Slide 26
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Gain in Surplus from Shared Living Arrangements
Least costlyProblem Ann’s cost of Betty’s cost of solution to
solving problem solving problem the problem
Total cost ofseparate apartments
(2)($400/month) $600/month $200/month= $800/month
Total cost ofshared apartment
Rent savings From sharing
Benefits of Shared Living
Costs of Shared Living
Ann’s phone usage Curtailed Tolerate phone Betty toleratesphone usage: usage: $150/mo. Ann’s phone
usage: $250/mo. $150/mo.
Gain in Surplus from Shared Living
Rent savings Least costly accommodation Gain in surplus($200/month) to shared living problems $50/month
($150/month)
How much should Ann and Betty pay if theyagree to split their economic surplus equally?
Chapter 11: Externalities and Property Rights Slide 27
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Legal Remedies for ExternalitiesWhen 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.
Chapter 11: Externalities and Property Rights Slide 28
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Legal Remedies for ExternalitiesWhen 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.
Chapter 11: Externalities and Property Rights Slide 29
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Economic NaturalistWhat is the purpose of speed limits and
traffic laws?
Chapter 11: Externalities and Property Rights Slide 30
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Economic NaturalistWhy do most communities have zoning
laws?
Chapter 11: Externalities and Property Rights Slide 31
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Economic NaturalistWhy do many governments enact laws that
limit the discharge of environmental pollutants?
Chapter 11: Externalities and Property Rights Slide 32
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Economic NaturalistWhat is the purpose of free speech laws?
Chapter 11: Externalities and Property Rights Slide 33
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
External Costs and Benefits
Economic NaturalistWhy does government subsidize the
planting of trees on hillsides?
Chapter 11: Externalities and Property Rights Slide 34
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
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
Chapter 11: Externalities and Property Rights Slide 35
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Problem of Unpriced ResourcesWhen 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
Chapter 11: Externalities and Property Rights Slide 36
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Number of steerson the commons
1 126 26
2 119 19
3 116 16
4 113 13
5 111 11
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 BetweenHerd Size and Steer Price
Individual choice• 4 steers = $52• 1 bonds = $13• Total Income = $65
Act individually to maximize income
Chapter 11: Externalities and Property Rights Slide 37
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Marginal Income and theSocially Optimal Herd Size
1 126 26 2626
2 119 19 3812
3 116 16 4810
4 113 13 52 4
5 111 11 55 3
Act collectively tomaximize village incomeSocially optimal choice• 1 steer = $26• 4 bonds = $52• Total Income = $78
Individual choice• 4 steers = $52• 1 bonds = $13• Total Income = $65
Number of steerson the commons
Price per2-year-old steer
($)
Incomeper steer($/year)
Total cattleIncome($/year)
MarginalIncome($/year)
Act individually to maximize income
Chapter 11: Externalities and Property Rights Slide 38
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the 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.
Chapter 11: Externalities and Property Rights Slide 39
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
One person’s use of the commons imposes an external cost on the others by making the property less valuable.
Chapter 11: Externalities and Property Rights Slide 40
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
The Effect of Private OwnershipExample
How much will the right to control the village commons sell for?
Chapter 11: Externalities and Property Rights Slide 41
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
The Effect of Private OwnershipAssume
Villagers can borrow and lend at 13%.The villagers decide to auction off the rights to
the commons.One steer is the optimal number
Chapter 11: Externalities and Property Rights Slide 42
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
The Effect of Private OwnershipAssume
Income from one steer = $26.Pay $100 for the commons
o 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:o (4 x $13) + $26 = $78 oro (4 x $13) + $13 rent + $13 highest bidder = $78
Chapter 11: Externalities and Property Rights Slide 43
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
The Effect of Private OwnershipObservations
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.
Chapter 11: Externalities and Property Rights Slide 44
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
Zoning laws and other regulations restrict the use of private property.
The laws can be used to maximize economic surplus.
Chapter 11: Externalities and Property Rights Slide 45
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
The laws can also be used to achieve an individual goal (reelection) by reducing the economic surplus.
Chapter 11: Externalities and Property Rights Slide 46
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
Private ownership may be impractical.
Economic NaturalistWhy do blackberries in public parks get
picked too soon?Why are shared milkshakes consumed too
quickly?
Chapter 11: Externalities and Property Rights Slide 47
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Property Rights and the Tragedy of Commons
When Private Ownership is ImpracticalHarvesting timer on remote public landHarvesting whales in international watersControlling multinational environmental
pollution
Chapter 11: Externalities and Property Rights Slide 48
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
When Payoffs Depend on Relative PerformanceIn 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.
Chapter 11: Externalities and Property Rights Slide 49
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
When Payoffs Depend on Relative PerformanceIn 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.
Chapter 11: Externalities and Property Rights Slide 50
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Economic NaturalistWhy do football players take anabolic
steroids?Smith and Jones are competing for a single
position and a $1 million contract.
Chapter 11: Externalities and Property Rights Slide 51
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Payoff Matrix forSteroid Consumption
Each has 50%chance of winning
Jones Wins
Smith WinsEach has a 50%
chance of winning
Don’t takesteroids
Jones
Smith
Takesteroids
Don’t takesteroids
Takesteroids
•Dominant strategy for each yields the third best outcome•This prisoner’s dilemma outcome is the attraction of rules banning performance enhancing drugs.
Chapter 11: Externalities and Property Rights Slide 52
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Positional ExternalityWhen an increase in one person’s
performance reduces the expected reward of another in situations in which reward depends on relative performance
Chapter 11: Externalities and Property Rights Slide 53
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Economic NaturalistWhy do grocery stores stay open all night,
even in small towns?
Chapter 11: Externalities and Property Rights Slide 54
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Economic NaturalistTwo stores considering whether or not to
stay open until 1:00 a.m.
Chapter 11: Externalities and Property Rights Slide 55
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Payoff Matrix for Extended Shopping Hours
Second bestfor each
Best for WegmansWorst for Tops
Best for TopsWorst for Wegmans
Third best for each
Close atmidnight
Wegmans
Tops
Close at1:00 A.M.
Close atmidnight
Close at1:00 A.M.
• Customers will choose the store with the most convenient hours, assuming all other variables are the same
• Both stores will stay open• Why will they stay open 24 hours?• Could a local law solve their problem?
Chapter 11: Externalities and Property Rights Slide 56
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Positional Arms RaceA series of mutually offsetting investments
in performance enhancement that is stimulated by a positional externality?
Chapter 11: Externalities and Property Rights Slide 57
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Positional Arms Control AgreementsAn agreement in which contestants attempt
to limit mutually offsetting investments in performance enhancements
Chapter 11: Externalities and Property Rights Slide 58
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Positional Arms Control AgreementsCampaign spending limitsRoster limitsArbitration agreementsMandatory starting dates for kindergarten
Chapter 11: Externalities and Property Rights Slide 59
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Positional Externalities
Social Norms as Positional Arms Control AgreementsNerd normsFashion normsNorms of tasteNorms against vanity
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