Chapter 11 Externalities and Property Rights

1
Chapter 11Externalities and Property Rights

• Q. 1, 5, 8, 9

2
Problem 1, Chapter 11

• Determine whether the following statements are
  true or false, and briefly explain why
• A) A given total emission reduction in a
  polluting industry will be achieved at the lowest
  possible total cost when the cost of the last
  unit of pollution curbed is equal for each firm
  in the industry
• B) In an attempt to lower their costs of
  production, firms sometimes succeed merely in
  shifting costs to outsiders

3
Solution to Problem 1 (1)

• A) True
• Application of Equal Marginal Principle
• For optimal allocation of production, marginal
  cost should be the same across all the firms
• If one firms marginal cost is higher than the
  others, it is cost-minimizing to divert the
  production from the firm with a higher marginal
  cost to the firm with a lower marginal cost

4
Solution to Problem 1 (2)

• B) True
• Notion of Negative Externality
• It refers to situation where producers do not
  bear the complete production cost and the leakage
  is borne by a three-party outside the market
• Consider an example of production that generates
  sewage
• The sewage is supposed to be collected by a
  municipal government at a per unit charge
• However, the manufacturer escapes from the
  discharge fee by pumping the sewage into a river
• The river gets polluted and the society then
  bears an extra pollution cost

5
Problem 5, Chapter 11

• Suppose the law says that Jones may not emit
  smoke from his factory unless he gets permission
  from Smith, who lives downward. If the relevant
  costs and benefits of filtering the smoke from
  Jones' production process are as shown in the
  following table, and if Jones and Smith can
  negotiate with one another at no cost, will Jones
  emit smoke?

6
Solution to Problem 5 (1)

• The efficient outcome is for Jones to emit smoke
• Why?
• The total surplus for Jones to emit smoke (600)
  is greater than the total surplus for Jones not
  to emit smoke (580)
• Jones gains more surplus by emitting smoke (200
  - 160 40)
• Smith gains less surplus by authorizing Jones
  emit smoke (420 - 400 -20)
• Note that Smith has the right to authorize Jones
  emit or not emit smoke

7
Solution to Problem 5 (2)

• Since both Jones and Smith can negotiate with one
  another at no cost, they can actually come up
  with a plan that is mutually beneficial
• In order to induce Smith authorize Jones to emit
  smoke, Jones can offer Smith a side payment 30
  to Smith, so that Smiths lost in surplus (-20)
  can be fully covered plus some extra gain (10)
• Even if Jones has to pay Smith 30, Jones still
  gains 10 from the deal

8
Problem 8, Chapter 11 (1)

• Barton and Statler are neighours in an apartment
  complex in downtown Manhattan. Barton is a
  concert pianist, and Statler is a poet working on
  an epic poem. Barton rehearses his concert pieces
  on the baby grand piano in his front room, which
  is directly above Statlers study. The following
  matrix shows the monthly payoffs to Barton and
  Statler when Bartons front room is and is not
  soundproofed. The soundproofing will be effective
  only if it is installed in Bartons apartment.

9
Problem 8, Chapter 11 (2)
10
Solution to Problem 8 (1)

• A) If Barton has the legal right to make any
  amount of noise he wants and he and Statler can
  negotiate with one another at no cost, will
  Barton install and maintain soundproofing?
  Explain. Is his choice socially efficient?
• His choice is socially efficient
• Bartons payoff without soundproofing is 50
  greater than his payoff with soundproofing
• Barton has the legal right to make noise
• He will of course not install the soundproof
  unless he receives an additional income of at
  least 50

11
Solution to Problem 8 (2)

• Statlers payoff without soundproofing is 40
  less than his payoff with soundproofing
• Statlers additional payoff from having a
  soundproof is not sufficient to feed Bartons
  additional payoff from not having a soundproof
• Both Barton and Statler will have no intention to
  negotiate with one another
• Since the total payoff from not having a
  soundproof (230) is greater than the total
  payoff from having it (220), it is socially
  efficient

12
Solution to Problem 8 (3)

• We can notice that an inequitable allocation of
  payoff can be socially efficient!
• B) If Statler has the legal right to peace and
  quiet and can negotiate with Barton at no cost,
  will Barton install and maintain soundproofing?
  Explain. Is his choice socially efficient?
• As Statlers payoff with soundproofing is 40
  greater than his payoff without soundproofing, he
  will exercise his right to require Barton to
  install and maintain a soundproof

13
Solution to Problem 8 (4)

• The total payoff will then be 220, which is less
  than the total payoff without soundproofing
  (230)
• Statlers choice is thus not socially efficient
• However, the negotiation cost is zero
• Barton will have an intention to negotiate with
  Statler on not installing the soundproof by
  providing Statler a compensation of 40
  (Statlers additional payoff from having a
  soundproof)
• Barton is willing to make this compensation, as
  he can gain an additional payoff from not having
  a soundproof
• If such transaction occurs, the result will then
  be socially efficient

14
Solution to Problem 8 (5)

• C) Does the attainment of an efficient outcome
  depend on whether Barton has the legal right to
  make noise, or Statler the legal right to peace
  and quiet?
• No, it is actually independent of who has the
  legal right on either issues.
• Parts a and b arrive with the same result
• However, it is only true because the negotiation
  cost is zero in this case
• If the negotiation cost is high enough to make
  transfer or compensation infeasible, the
  attainment of an efficient outcome will then
  become dependent on who has the legal right on
  either issues

15
Problem 9, Chapter 11

• Refer to problem 8. Barton decides to buy a
  full-sized grand piano. The new payoff matrix is
  shown in the matrix below

16
Solution to Problem 9 (1)

• A) If Statler has the legal right to peace and
  quiet, and Barton and Statler can negotiate at no
  cost, will Barton install and maintain
  soundproofing? Explain. Is this outcome socially
  efficient?
• Statlers payoff with soundproofing is 60
  greater than his payoff without soundproofing
• He has the legal to peace and quiet
• Thus, Statler will exercise his right to require
  Barton to install and maintain a soundproof

17
Solution to Problem 9 (2)

• Barton will not have an intention to negotiate
  with Statler, as Bartons additional payoff from
  not having a soundproof (50) is not enough to
  provide a compensation for Statlers additional
  payoff from having a soundproof (60)
• Therefore, they will end up having a soundproof
  installed and maintained
• It is an efficient outcome
• The total payoff from having a soundproof is 10
  greater than the total payoff from not having a
  soundproof

18
Solution to Problem 9 (3)

• B) Suppose that Barton has the legal right to
  make as much noise as he likes and that
  negotiating an agreement with Barton costs 15
  per month. Will Barton install and maintain
  soundproofing? Explain. Is this outcome socially
  efficient?
• Bartons payoff without soundproofing is 50
  greater than his payoff with soundproofing
• Barton has the legal right to make noise
• He will of course not install the soundproof
  unless he receives an additional income of at
  least 50

19
Solution to Problem 9 (4)

• On the other side, Statlers payoff with
  soundproofing is 60 greater than his payoff
  without soundproofing
• However, Statler will have no intention to
  negotiate with Barton, as there is a negotiation
  cost of 15
• In order to reach an agreement with Barton to
  install a soundproof, Statler will need to pay a
  total of 65 (50 15)- it is beyond his
  additional payoff with soundproofing
• As the total payoff without soundproofing is 10
  less than the total payoff with soundproofing,
  the outcome is not socially efficient

20
Solution to Problem 9 (5)

• C) Suppose Statler has the legal right to peace
  and quiet, and it costs 15 per month for Statler
  and Barton to negotiate any agreement.
  (Compensation for noise damage can be paid
  without incurring negotiation cost.) Will Barton
  install and maintain soundproof? Is this outcome
  socially efficient?
• As Statlers payoff with soundproofing is 60
  greater than his payoff without soundproofing, he
  will exercise his right to require Barton to
  install and maintain a soundproof

21
Solution to Problem 9 (6)

• The total payoff will then be 220, which is
  greater than the total payoff without
  soundproofing (210)
• Statlers choice is thus socially efficient
• Barton will have no intention to negotiate with
  Statler on not installing the soundproof by
  providing Statler a compensation of 60
  (Statlers additional payoff from having a
  soundproof)

22
Solution to Problem 9 (7)

• D) Why does the attainment of a socially
  efficient outcome now depend on whether Barton
  has the legal right to make noise?
• It is attributed to the presence of negotiation
  cost
• The 15 negotiation cost blocks the efficient
  outcome, as total amount Statler has to pay to
  compensate for Bartons additional payoff with
  soundproofing (65) outweigh Statlers payoff
  with soundproofing (60)
• However, if Statler has the legal right to peace
  and quiet instead, no agreement is necessary to
  arrive at the efficient outcome