Title: Externalities and Property Rights
1Externalities and Property Rights
LECTURE
2External Costs and Benefits
- Sometimes costs or benefits that result from an
activity accrue to people not directly involved
in the activity. - These are called external costs or external
benefits -- externalities for short.
3External Costs and Benefits
- External Cost (negative externality)
- A cost of an activity that falls on people other
than those who pursue the activity. - Automobile exhaust
- Goods whose production generates toxic smoke
- Barking dogs (loud pets)
- Loud stereos in an apartment building.
4When Market Equilibrium is not Social Optimum
- In the market equilibrium for such goods, the
benefit to buyers of the last good produced is,
as before, equal to the cost incurred by sellers
to produce that good. - But producing that good also results in the costs
of the associated pollution. -
5When Market Equilibrium is not Social Optimum
- Then the full marginal cost of the last unit
produced - the sellers private marginal cost
plus the marginal pollution cost borne by others
- will be higher than the benefit of the last
unit produced. -
Social marginal cost private marginal cost
marginal
pollution cost
6External Costs in Production
Costs and benefits
MC S
P
D
Q1
Quantity
7External Costs in Production
Costs and benefits
MSC
MC S
P
D
Too much production
Social optimum
O
Q1
Quantity
8When Market Equilibrium is not Social Optimum
- When costs fall on people other than sellers
market equilibrium quantity gt socially optimal
quantity. - Total economic surplus would be higher if output
of the good were lower. - Yet neither sellers nor buyers have any incentive
to alter their behavior.
Potentially, some public policy can be
implemented to discourage the production of this
kind of goods.
9External Costs in Consumption
Costs and benefits
S
P
MBD
Q1
Quantity
10External Costs in Consumption
Costs and benefits
S
P
MBD
MSB
Too much production
Social optimum
Q1
Quantity
11External Costs and Benefits
- External Benefit (positive externality)
- A benefit of an activity received by people other
than those who pursue the activity. - Immunizations
- Restored historic buildings
- Research into new technologies
12When Market Equilibrium is not Social Optimum
- Here, the full marginal benefit of the last unit
produced - the price paid by the marginal buyer
plus the benefit received by non-buyers - will be
higher than the marginal cost of the last unit
produced.
Social marginal benefit private marginal
benefit marginal benefit
received by non-buyers
13External Benefits in Consumption
Costs and benefits
S
P
MBD
Q1
Quantity
14External Benefits in Consumption
Costs and benefits
S
MSB
P
MBD
Social optimum
Too little production
Q1
Quantity
15When Market Equilibrium is not Social Optimum
- Market equilibrium results in too little
production of goods that generate external
benefits.
Potentially, some public policy can be
implemented to encourage the production of this
kind of goods.
Public health programs Unvaccinated populations
are at risk. After vaccination rates dropped in
northern Nigeria in the early 2000s due to
religious and political objections, the number of
measles cases rose significantly, and hundreds of
children died.
16External Benefits in Production
Costs and benefits
MCS
P
D
O
Quantity
17External Benefits in Production
Costs and benefits
MSC
MCS
P
D
Social optimum
Too little production
O
Q2
Quantity
18How 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.
19How Externalities Affect Resource Allocation
- When an activity generates a negative
externality, the level of the activity will be
greater than the socially optimal level. - Negative externalities gt too much activity.
- When an activity generates a positive
externality, the level of the activity will be
less than the socially optimal level. - Positive externalities gt too little activity.
20Recall The Equilibrium Principle
- A market in equilibrium leaves no unexploited
opportunities for individuals, but may not
exploit all gains achievable through collective
action.
21Negative Externality and Deadweight Loss
- Without external costs QPVT is the social optimum
Social MC
Externality (XC)
MCPVT XC
MCSOC
Private MC
MCPVT
- With external costs the private MC lt social MC
and the private optimum is more than the social
optimum.
MB
QSOC
Qpvt
Deadweight loss from negative externality
Quantity
Too much production
22Positive Externality and Deadweight Loss
- With external benefits the private MB lt social MB
and the private optimum is less than the social
optimum.
MBPVT XB
MBSOC
Social demand private demand XB
QSOC
Deadweight loss from positive externality
Quantity (time in minutes)
Too little production
23Private Solutions to Externalities
- Paul can produce with or without a filter on his
smokestack. - Production without a filter results in greater
smoke damage to Janet.
24Private Solutions to Externalities
Without filter
With filter
Gains to Paul
Damage to Janet
- The Market
- Without filter Total economic surplus 245 -
85 160 - With filter Total economic surplus 200 - 35
165 - gt Total economic surplus goes up if Paul
installs the filter.
25Private Solutions to Externalities
- If Paul is not liable for smoke damages and if
the two parties can negotiate costlessly with one
another, will he install a filter?
26Private Solutions to Externalities
Without filter
With filter
Gains to Paul
Damage to Janet
- The filter costs 245-20045.
- Paul doesnt have to install it, but if Janet
pays him at least 45, he will gladly do so. - And since the filter results in savings of
85-3550 for Janet, she will pay Paul to
install the filter.
27Private Solutions to Externalities The Coase
Theorem
- If property rights are fully assigned and if
people can negotiate costlessly with one another,
they will always arrive at efficient solutions to
problems caused by externalities.
Ronald Coase (1910 - ), British economist, Nobel
Prize in Economics in 1991
28The Coase Theorem
- The Coase Theorem is a proposition that if
private parties can bargain without cost over the
allocation of resources, they can solve the
problem of externalities on their own. - Transaction costs are the costs that parties
incur in the process of agreeing to and following
through on a bargain.
29The Coase Theorem
- Traditional (pre-Coase) view
- Paul is the perpetrator, Janet is the victim.
- If it is Pauls smoke that is causing the damage
to Janet, why should Janet pay Paul to install a
filter on his smokestack?
30The Coase Theorem
- Coases insight was that externalities are purely
reciprocal. - The smoke harms Janet, true enough.
- But to restrain Paul from producing smoke would
harm Paul . - The two parties have a shared interest in
achieving the outcome that is least costly
overall.
31The Coase Theorem
- When the economic pie is larger, everyone can get
a larger slice.
Paul
Paul
Janet
Janet
Surplus with efficient solution
Surplus with inefficient solution
32External Cost and Costless Negotiation
- Ted and Bill can live together in a two-bedroom
apartment for 500/month
33External Cost and Costless Negotiation
- or each rent a one-bedroom apartment for
300/month.
34External Cost and Costless Negotiation
- If the rent were the same, they would be
indifferent between living together or
separately, except for one problem - Ted likes to practice his trumpet late at night
and this will disturb Bills sleep.
35External Cost and Costless Negotiation
- Ted would pay up to 150 per month rather than
reschedule his playing. - Bill would pay up to 80 per month not to have
his sleep disturbed. - Will they live together or separately?
36External Cost and Costless Negotiation
- The question is whether the benefits of joint
living exceed the costs. - The benefit is the 100 per month reduction in
rent. - What is the least costly accommodation to the
trumpet problem?
37External Cost and Costless Negotiation
- Costs
- Cost to Ted of stopping playing 150/month
- Cost to Bill of tolerating the noise 80/month
- So the least costly solution is for Bill to put
up with the noise (since 80 lt 150). - Since this cost is less than the 100 per month
gain, they should live together.
38The Gain in Surplus from Shared Living
Arrangements
39External Cost and Costless Negotiation
- What is the largest rent Bill would be willing to
pay if the two were to live together? - If Bill were to live alone, he would pay 300/mo
and suffer no trumpet noise. - Since the noise costs him 80/mo, the most he
would be willing to pay for the shared apartment
is 300 - 80 220.
40External Cost and Costless Negotiation
- How should Ted and Bill split the 500/mo rent if
they agree that each should benefit equally from
living together? - Their total gain from living together is 100 -
80 20/mo. - If Ted pays 290/mo and Bill pays 210/mo, each
will be 10/mo better off than if he were to live
alone.
41External Cost and Costless Negotiation
- When there is no barrier to negotiation (
costless negotiation) - Efficient solutions to externalities can be
found. - The adjustment to the externality is usually done
by the party with the lowest cost.
42Legal Remedies for Externalities
- However, it is often impractical to negotiate
solutions to the problems created by
externalities. - Example hospital patients are unable to
negotiate with passing motorists about not
blowing their horns.
43Legal Remedies for Externalities
- When negotiation is costly
- Laws may be used to correct for externalities.
- The burden of the law can be placed on those who
have the lowest cost.
44Legal Remedies for Externalities
- Example
- Not blowing his horn is a cost to the motorist,
but a benefit to the patient. - Because peace and quiet is especially valuable
for hospital patients, the law prohibits horn
blowing in the vicinity of hospitals.
45The Right to an Unobstructed View
- Lehman owns a house overlooking a lake, from
which he enjoys a commanding sunset view.
46The Right to an Unobstructed View
- Martin purchases the property below Lehmans and
is considering which of two houses to build - a one-storey house that would leave Lehmans view
intact - or a two-storey design that would completely
block Lehmans view.
47The Right to an Unobstructed View
- Suppose
- The gain to Lehman from an unobstructed view is
100, - The gain to Martin from a one-storey house is
200, - The gain to Martin from a two-storey house is
280.
48The Right to an Unobstructed View
- If the laws of property let people build houses
of any height they chose, and if negotiation
between property owners were costless, which of
the two houses would Martin build?
49The Right to an Unobstructed View
- Value of view to Lehman 100
- Value of second storey to Martin 280 200 80
- The increase in Martins gain from having the
taller house is 80, which is 20 less than the
cost to Lehman from the loss of his view.
50The Right to an Unobstructed View
- The efficient outcome is thus for Martin to build
the one-storey house. - That is exactly what would happen if the two
parties could negotiate costlessly.
51The Right to an Unobstructed View
- Rather than see Martin build the taller house, it
will be in Lehmans interest to compensate Martin
for choosing the shorter version. - To do so, he will have to give Martin at least
80. - The most Lehman would be willing to pay is 100,
since that is all the view is worth to him. - For some payment P, where 80 ? P ? 100, Lehman
will get to keep his view.
52The Right to an Unobstructed View
- Suppose, however, that negotiations between the
two parties were impractical. - Martin would then go ahead with the two-storey
house, since that is the version he values most.
- By comparison with the one-storey design, Martin
would gain 80, but Lehman would lose 100.
53The Right to an Unobstructed View
- The optimal structure of property rights in this
particular example would be to prohibit any
building that blocks a neighbors view.
54The Right to an Unobstructed View
- If the valuations assigned by the parties were
different, a different conclusion might follow. - If Martin valued the two-storey house at 300 and
Lehman valued the view at only 80, the optimal
structure of property rights would be to allow
people to build to whatever height they chose.
55Modified Coase Theorem
- The optimal structure of property rights is the
one that places the burden of adjustment (either
the loss of a view or the loss of a preferred
building design) on the party that can accomplish
it at the lowest cost.
56Modified Coase Theorem
- As a practical matter, the laws of property often
embody this principle. - Even in cities that have no special view to
protect at all, zoning laws generally limit the
fraction of the lot that can be occupied by
manmade structures. - Most people value access to at least some
sunlight, and ordinances of this sort make it
possible for them to get it.
57Solutions to Externality
- Private solutions
- Coase theorem
- Assumption no transaction costs, clearly
assigned property rights - Efficient allocation regardless of assignment of
property rights - Modified Coase Theorem
- Assign property rights to the party with the
least cost of adjustment - Public solutions?
58Public Policies Toward Pollution
- When externalities are significant and private
solutions are not found, the government may
attempt to solve the problem through . . . - command-and-control policies.
- market-based policies.
59Public Policies Toward Pollution
- Command-and-Control Policies
- Usually take the form of regulations
- Forbid certain behaviors.
- Require certain behaviors.
- Examples
- Requirements that all students be immunized.
- Stipulations on pollution emission levels set by
the Environmental Protection Agency (EPA).
60Public Policies Toward Pollution
- Market-Based Policies
- Government uses taxes and subsidies to align
private incentives with social efficiency. - Pigovian taxes are taxes enacted to correct the
effects of a negative externality.
61Application The Economics of Pollution
- Pollution is a bad thing... Yet most pollution is
a side effect of activities that provide us with
good things - Our air is polluted by power plants generating
the electricity that lights our cities, and our
rivers are damaged by fertilizer runoff from
farms that grow our food - Then, how much pollution should a society have?
62Public Policies Toward Pollution
- Regulation versus Pigovian Tax
- If the EPA decides it wants to reduce the amount
of pollution coming from a specific plant, the
EPA could - tell the firm to reduce its pollution by a
specific amount (i.e. regulation). - levy a tax of a given amount for each unit of
pollution the firm emits (i.e. Pigovian tax).
63Public Policies Toward Pollution
- Environmental standards rules that protect the
environment by specifying actions by producers
and consumers. - Emission tax a tax that depends on the amount of
pollution a firm produces. - Tradable emissions permits licenses to emit
limited quantities of pollutants that can be
bought and sold by polluters.
64Public Policies Toward Pollution
- Market-Based Policies
- Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm to
another. - A market for these permits will eventually
develop. - A firm that can reduce pollution at a low cost
may prefer to sell its permit to a firm that can
reduce pollution only at a high cost.
65Taxing Negative Externalities
- Two firms, X and Y, have access to five different
production processes each one has a different
cost and gives off a different amount of
pollution.
66Taxing Negative Externalities
- If pollution is unregulated, and negotiation
between the firms and their victims is
impossible - Each firm will use A, the least costly of the
five processes. - Each will emit 4 tons of pollution per day, for a
total pollution of 8 tons/day.
67Taxing Negative Externalities
- The City Council wants to cut smoke emissions by
half and is considering two options - Policy A Require each firm to curtail its
emissions by half. - Policy B Set a tax of T on each ton of smoke
emitted each day.
68Taxing Negative Externalities
- How large would T have to be in order to curtail
emissions by half? - How would the total cost to society compare under
the two alternatives?
69Taxing Negative Externalities
- Policy A
- If each firm is required to cut pollution by
half, each must switch from process A to process
C.
70Taxing Negative Externalities
- Costs of the switch
- For firm X 700/day - 200/day 500/day.
- For firm Y 140/day - 50/day 90/day,
- Total cost for the two firms 590/day.
71Taxing Negative Externalities
- Policy B How will each firm respond to a tax of
T per ton of pollution? - Switching to the next process will cut pollution
by 1 ton per day and save tax of T/day. - If the cost of switching to the next process is
less than or equal to T, the firm will switch,
otherwise not.
72Taxing Negative Externalities
- If T 50/ton
- Firm X would stick with process A.
- Firm Y will switch to process B.
73Taxing Negative Externalities
- If T 91/ton
- Firm X will switch to process B.
- Firm Y will switch to process D.
74Taxing Negative Externalities
- Costs of the switch
- For firm X 290/day-200/day 90/day.
- For firm Y 230/day-50/day 180/day.
- Total cost for both firms is thus only 270/day,
or 320/day less than the cost of having each
firm cut pollution by half.
75Taxing Negative Externalities
- The direct regulatory approach of requiring each
firm to cut by half took no account of the fact
that firm Y can reduce pollution much more
cheaply than firm X can. - The advantage of the tax approach is that it
concentrates pollution reduction in the hands of
the firms that can accomplish it in the least
costly way.
76Taxing a Negative Externality
Private equilibrium without pollution tax
Private equilibrium with pollution tax
Social MC Private MC XC
Private MC Tax
XC
Tax
P(S)
P(S)
Price
Price
Private MC
Private MC
P(P)
P(P)
D
D
P
S
Social optimum
Private equilibrium
Quantity
Quantity
Note The optimal amount of negative
externalities is not zero
77Pollution Permits
- Suppose now that the City Council issues
pollution permits to the two firms, allowing them
to generate 4 tons of smoke daily, in total. - Will the pollution generated by the two firms
change with the different allocation of permits?
78Pollution Permits
- Suppose each firm is given permits to generate 2
tons of smoke.
By moving from C to B, Firm X will generate 1
more ton of smoke but will save a cost of 410.
By moving from C to D, Firm Y will incur a cost
of 90. Negotiation will ensure the new
allocation (3 tons for firm X, and 1 ton for firm
Y).
79Pollution Permits
- Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm to
another. - A market for these permits will eventually
develop. - A firm that can reduce pollution at a low cost
may prefer to sell its permit to a firm that can
reduce pollution only at a high cost.
80The Tragedy of the Commons
- A common is an area that is owned by all
members of a group or a society and is accessible
by all. - The key feature of common property is that it can
be used by anyone, and most users use it without
any thought about what their use will do to the
possible use by other people.
81The Tragedy of the Commons
- Common resources left to the free market suffer
from overuse a user depletes the amount of the
common resource available to others but does not
take this cost into account when deciding how
much to use the common resource. - The tragedy of the commons describes situations
in which valuable resources are destroyed because
users are not charged for them.
82The Tragedy of the Commons
- First introduced in 1833 by William Forster
Lloyd, a political economist at Oxford
University, looking at the recurring devastation
of common ( not privately owned) pastures in
England.
83The Tragedy of the Commons
- Once a resource is being used at a rate near its
sustainable capacity, any additional use will
reduce its value to its current users. - Thus they will increase their usage to maintain
the value of the resource to them, resulting in a
further deterioration in its value, and so on,
until no value remains.
84The Tragedy of the Commons
- A village has five residents, each of whom has
accumulated savings of 100. - Each villager has two investment options
- Buy government bond for 100 that pays 12
interest per year. - Buy a year-old steer for 100, send it onto the
commons to graze, then sell it after one year. - Investment decisions are individual and public.
85The Tragedy of the Commons
- If each person decides individually how to
invest, how many steers will be sent onto the
commons? - Will there be a socially optimal outcome?
86The Tragedy of the Commons
- Private decision
- Opportunity cost of investing in steer 12
- Send steer if and only if price of 2-year-old
steer is at least 112. - Decision rule for socially optimal investment
- Send another steer only if the value of the herd
increases by at least 12.
Income per steer
Marginal income
87Private Decision
Act individually to maximize income
- Individual choice
- 4 steers 48
- 1 bond 12
- Village total income 12 4x12 60
88Socially Optimal Herd Size
Income per steer (/year)
Total cattle Income (/year)
Marginal Income (/year)
Price per 2-year-old steer ()
Number of steers on the commons
1 120 20 20 20 2 116 16 32 12 3 114 14 42 10 4
112 12 48 6 5 110 10 50 2
Act individually to maximize income
Act collectively to maximize village income
- Socially optimal choice
- 2 steers 32
- 3 bonds 36
- Total Income 68
- Individual choice
- 4 steers 48
- 1 bonds 12
- Total Income 60
89The Problem of Unpriced Resources
- The problem with private decisions is that no
individual has any incentive to take into account
that an extra steer will eat grass that otherwise
would have been available to the steers already
on the commons. - When no one owns the commons, the opportunity
cost of using it is not considered.
90The Problem of Unpriced Resources
- When they operate alone, each grazer imposes an
external cost on the others a negative
externality by making the property less valuable
( the reduced return to every steer).
91The Tragedy of the Commons
- The externality can be internalized by switching
to group action - The group of five changes the incentive structure
from maximizing for each to maximizing for all. - The marginal reward to the group is different
from the marginal reward to the individuals.
92- Examples of Tragedies of the Commons
Harvesting timber on public land
- Each tree cutter knows that a tree not harvested
this year will be bigger, and hence more
valuable, next year. - But he also knows that if he doesnt cut the tree
down this year, someone else will.
93- Examples of Tragedies of the Commons
Harvesting whales in international waters
- Each individual whaler knows that harvesting an
extra whale reduces the breeding population of
whales and hence the size of future whale
populations. - But he also knows that any whale he fails to
harvest today will just be taken by some other
whaler.
94- Examples of Tragedies of the Commons
Environmental pollution
- Each individual polluter has no incentive to take
into account the cost his pollution imposes on
others.
95Going Back to Chapter 1
- Problem 4 (page 20)
- Once a week, Smith purchases a six-pack of cola
and puts it in his refrigerator for his two
children. He invariably discovers that all six
cans are gone on the first day. - Jones also purchases a six-pack of cola once a
week for his two children, but unlike Smith, he
tells them that each may drink no more than three
cans. - If the children use cost-benefit analysis each
time they decide whether to drink a can of cola,
explain why the cola lasts much longer at Jones
house than at Smiths.
96Going Back to Chapter 1
- At Smiths house, each child knows that the cost
of not drinking a can of cola now is that it is
likely to end up being drunk by his sibling. - Each child has an incentive to consume rapidly to
prevent the other from encroaching on his share.
97Going Back to Chapter 1
- Jones, by contrast, has eliminated that incentive
by making sure that neither child can drink more
than half the cans. - This step permits his children to consume at a
slower, more enjoyable pace.
98Defined Property Rights as a Solution to the
Tragedy of the Commons
- Characteristics of property rights
- Rights must be specified ( what and where the
property is). - Rights must be exclusive ( gives the property
owner access to any rewards yielded by the
property). - Rights must be transferable ( can be bought and
sold in a well-defined and operating market). - Rights must be enforceable and enforced.
99Defined Property Rights as a Solution to the
Tragedy of the Commons
- doesnt cut trees down
too quickly on its own land.
100Defined Property Rights as a Solution to the
Tragedy of the Commons
People dont dump toxic wastes into their own
swimming pools.
101Regulations as a Solution to the Tragedy of the
Commons
- Private property removes the problem of the
common. - Regulations can do the same when private
ownership is impractical - Harvesting timber on remote public land
- Harvesting whales in international waters
- Controlling multinational environmental pollution
102Regulations as a Solution to the Tragedy of the
Commons
Fishing licenses limit the amount of fish that
can be taken.
103Regulations as a Solution to the Tragedy of the
Commons
104Regulations as a Solution to the Tragedy of the
Commons
- Laws regulate air and water pollutants.
105Regulations as a Solution to the Tragedy of the
Commons
- Zoning laws limit the size and other features of
buildings, signs, land-use patterns, etc.
106Taxation as a Solution to the Tragedy of the
Commons
- Taxes also lead people to account for how their
actions affect others. - Example In the cattle-grazing economy, suppose
there is now a 25 tax on income earned from
cattle. - If people decide individually between bonds and
cattle, how many steers will be sent onto the
commons?
107Taxation as a Solution to the Tragedy of the
Commons
With a 25 tax on income from cattle, only 2
steers will be sent onto the commons, and this is
the socially optimal number.
Total income 3x12 2x12 8
68 (bonds) (cattle) (tax)
108Positional Externalities
- Positional externalities occur when an increase
in one persons performance reduces the expected
reward of another in situations in which reward
depends on relative performance. - Frequent in activities where competition for
position is very intense and the difference
between first place and second place is well
defined.
109Positional Externalities
- When the payoff depends on relative performance,
incentive to invest in performance activities
will be excessive from a collective point of view.
110Positional Externalities
- Example 24-hour grocery stores
- Strategy to close the latest to serve more
customers. - But at night, there are not so many customers
111Payoff Matrix for 24-hour Opening
Supermarket A
Close at midnight
Close at 100am
Close at midnight
Supermarket B
Close at 100am
gt Dominant strategy for each yields the third
best outcome
112Positional Externalities
- In such situations, the convenience of an
all-night shopping option could be maintained at
lower cost - By limiting business hours,
- Or by permitting stores to limit hours, perhaps
through an agreement whereby each store serves in
turn as the only all-night grocery.
113Positional Arms Races
- Positional externalities stimulate positional
arms races ( series of mutually offsetting
investments in performance enhancement). - Examples
- Advertising.
- Use of illegal performance enhancing drugs in
sport. - Political campaign spending.
114Positional Arms Control Agreements
- An agreement in which contestants try to limit
mutually offsetting investments in performance
enhancements. - Examples
- Campaign spending limits.
- Anti-doping measures.
- Social norms.
115End of ECON1001