Chapter 11: Externalities & Property Rights

Part I

Externality

An externality (or spillover) is a cost or benefit arising from an economic activity that falls on people who do not participate in that activity. Disposal of chemical wastes in a river (negative

production externality) Proving a mathematical theorem (positive production

externality) Consumption of Liquor (negative consumption

externality) Consumption of education (positive consumption

externality)

How effective do the private resolve the problem of externalities

Consider a doctor whose ability to examine patients is disrupted by the noise of machinery operated by a confectioner (candy maker) in an adjacent building.

Historically, the economic and legal view is simple and clear: the confectioner’s noise is harming the doctor and should be restrained.

Challenge by Coase (1960): The confectioner’s noise does harm the doctor. But if we prevent the noise, we harm the confectioner.

The Coase Theorem

Suppose the damage inflicted to the doctor is 40, while the gain the confectioner receives from operating the shop is 60. When bargaining cost is low, the same efficient outcome prevails (the confectioner will keep on operating).

If confectioner is liable for his damage to the doctor, he will pay the doctor in order to harass him. If not, the confectioner will simply ignore the doctor and keep on operating.

Coase theorem states that: When the parties affected by externalities can negotiate costlessly with one another, the efficient outcome results no matter how the law assigns liability for damages. (In the absence of transaction cost, ownership does not matter.)

Gain to the confectioner from operating w/o soundproofing: 60; soundproofing costs 20; loss to the doctor: 40; cost of negotiation: 25.

net benefit

legal regime

outcome doctor confectioner total

confectioner liable

confectioner installs soundproofing at his oown cost

40 40 80

not liable confectioner does not install soundproofing; doctor shuts down

0 60 60

In the presence of negotiation costs, the efficient outcome (confectioner to install soundproofing) emerges only when he is made liable for noise damage.

Is Coase theorem relevant?

Why the Coase theorem may not work in practice? Sunk costs--the one who initiates the

negotiation will have some cost sunk upfront. Transaction costs--costs of negotiating, writing

and enforcing a contract. Multiple parties--the issue may involve a large

number of people, and reaching an arrangement among such a large number of people is prohibitively difficult.

Some applications of the Coase theorem why smoking in public is prohibited but in private

is not?

why protecting freedom of speech when it could be wrongly used?

For a developer to build a hotel in the airspace above my land, he must first secure my permission. But the law permits commercial airliners to fly over my land without payment whenever they choose. Why this distinction?

Externality and Supply Curve

0 1 2 3 4quantity

Supply based on private cost only

Supply after taking external cost into consideration

External cost per unit of output=marginal external cost

Negative Production Externality Leads to Overproduction

Quantity (tons of Aluminum)

Pri

ce, c

ost,

an

d be

nefi

t (d

olla

rs/t

on o

f A

l)

C1

0

D

Supply when externality is taken into account

P0

P1

SC0

Q1 Q0

Supply when externality is not taken into account

Pollution cost(Externalcost)

Competitiveequilibrium

Point ofallocativeefficiency

Public Policy on Externalities

Government has a wide range of measures to deal with negative production externalities (e.g. chemical waste) Complete prohibition Quantity Restriction Pollution tax (Pigou tax) Marketable Permits Improvement in Pollution Abatement

Technology

Quantity Restriction vs Pigou Tax

Suppose there are two firms A and B each releasing 600 tons of wastes into water each year. And the government wants to restrict to a total of 600 tons each year. It could restrict each firm to release up to 300 tons of waste a year. (quantity restriction)

Taxes can be used to provide incentives for firms A and B to cut back on its production that creates external costs. For instance, levy a pollution tax of $20K/ton of waste. (Pigou tax)

Quantity Restriction vs Pigou Tax

Suppose both measures can achieve the 600 tons target. Then which is better?

Most economists think that taxation is better than quantity restriction.

Suppose the cost of abatement for firm A is $10K per ton and for firm B is $50K per ton.

Then each reducing to 300 tons of wastes requires a total cost of $10K x 300 + $50K x 300 = $18M.

Quantity Restriction vs Pigou Tax

Clearly, the least costly way is to let firm A do all the abatement. Total cost = $10K X 600 = $6M.

To implement this outcome, the government can levy a pollution tax of $20K per ton. Then firm A will do all the abatement.

Marketable Permits

Besides Pigou tax, government can also issue marketable permits to all involving firms.

e.g. Issue a permit to firm A and firm B, respectively, to allow each of them to release up to 300 tons of waste a year. Then firm B will buy a permit of 300 tons from firm A to release up to 600 tons of waste.

Market Environmentalism!!! Issuing marketable permits requires the least information on the part of government about the industry.

Currently used by the EU countries to control carbon dioxide release.

Part II

Public Goods and Common Resources

Nonrivalry and Nonexcludability

Non-rivalry A good is nonrival if the consumption by

one person does not decrease the consumption by another

Non-excludability A good is nonexcludable if it is

impossible, or extremely costly, to prevent someone from benefiting from a good

Public Goods and Private Goods

Fish in the ocean

AirCongested highway

Pure private goods Club goods

Common resources Pure public goods

Food

Car

House

Cable television

Bridge, Non-

congested toll road

Lighthouse

National defense

Non-cong. highway

Rival?Yes No

Exc

lud

able

?

No

Yes

Fisheries--Many fisheries have common access such that anyone can fish and no one has a property right to a fish until it is caught.

Many species have been driven to extinction. The catch of Atlantic cod fell from about 4 million tons in the mid-60s to about 1 million tons today due to overfishing. The tragedy of commons!

Common Resource

Case: Easter Island: tragedy of commons? Easter Island is a small Pacific island over 3,200 km

from the coast of Chile, with a population of 2.1k. Viewed as a major archaeological and

anthropological mystery.

Enormous statues, carved from volcanic stone. Many rested on large platforms at various locations on the

island largest “moveable” statues weigh > 80 tons the largest yet unfinished weighs ~ 270 tons

Easter Island

Easter Island

the culture seemed too poor to support a large artisan class

the statues were moved substantial distances; the population too small to move the larger statues

the island had no trees suitable for making tools such as levers, rollers, rope and wooden sleds

Conclusion: rising wealth and rising population, followed by decline.

Easter Island: Brander & Taylor (1998, AER) To explain: the cyclical overshooting on Easter

Island vs the monotonic behavior on the major Polynesian islands

All else the same: no a priori reason to believe difference in demographics, tastes, or technology.

The only variable: nature of resource. palm tree on Easter Island is a very slow-growing palm (40 to 60 years to yield fruit). It grows nowhere else in Polynesia, and probably the only palm that can live in Easter Island’s relatively cool climate.

Easter Island: Brander & Taylor

The two most common large palms in Polynesia are the Cocos (cononut palm) and the Pritchardia (Fuji fan palm). Neither of these palms can grow on Easter Island, and both are fast-growing trees that reach fruit-growing age in approximately 7 to 10 years.

Resource and population dynamics: slow regeneration

population

Resource stock

Year (A.D.)400 1900

Res

ourc

e an

d po

pula

tion

sto

ck

012

,000

Key parameter: resource growth rate: 0.04

Resource and population dynamics: fast regeneration

population

Resource stock

Year (A.D.)400 1900

Res

ourc

e an

d po

pula

tion

sto

ck

012

,000

Key parameter: resource growth rate: 0.35