Chapter 12

Externalities and Property

Rights

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Externalities

Spillover costs and benefits associated with production and consumption of certain goods and services which is not accounted for by the price system

Results on others not accompanied by their actions

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Externalities:

Positive externalities: – External benefits– Spillover benefits– A benefit of an activity received by people other

than those who pursue the activity– Example:

Negative externalities– External costs– Spillover costs– A cost of an activity that falls on people other than

those who pursue the activity– Example:

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Examples of External Costs:

Power plants Paper making Farming Concert Driving Smoking

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Examples of External Benefits:

Honeybee keeper Park Neighborhood Infrastructure ……

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Costs & Benefits: Private vs. Social

Social benefits: benefit enjoyed but not paid for by other members in the society

Social costs: costs to other members of the society which is not compensated

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How Externalities Affect Resource Allocation

Positive externality of keeping honeybees– Bees pollinate the apple orchards.– External benefit to the apple growers (social

benefit)– optimal number of hives: to the keeper vs. to the

community Negative Externality of keeping honeybees

– Hives located near a school and nursing home may cause more people to get stung by the bees.

– Optimal number of hives: to the keeper vs. to the community

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How Externalities Affect Resource Allocation

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.

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.

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Conclusion:

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.

When an activity generates a negative externality, the level of the activity will be greater than the socially optimal level.

When an activity generates a positive externality, the level of the activity will be less than the socially optimal level.

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How External Costs Affect Resource Allocation

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A good whose production generates a positive externality for consumers

Figure 12.2, P.314

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Private Solutions to Negative Externalities

Inefficiency:

through rearrangement, it is possible to make at least some people better off without harming others

– Internalization of externality: individuals take externalities into account when making decision

– Coase theorem: externalities need not lead to inefficiency because individuals have an incentive to make mutually beneficial deals

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Coase Theorem

If, at zero 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.

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Example 12.3 ， P.315

The Market– Abercrombie’s company produces a toxic

waste.– If the waste is dumped into the river, Fitch

cannot fish in the river.– Should Abercrombie install a filter?

• Assume there is no communication cost between Abercrombie and Fitch

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$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 = $20Solution: •Fitch pays Abercrombie at least $30 per day.•Abercrombie operates with filter.•Total benefit is larger than without filter.

Table 12.1, P.315

Costs and Benefits of Eliminating Toxic Waste

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$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

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$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•Socially optimal quantity of pollution is not zero

Table 12.2, P.317

Costs and Benefits of Eliminating Toxic Waste

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Coase Theorem: again

When 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

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When 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.

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Legal Remedies for Externalities

Speed limits and traffic laws Zoning laws Limits on discharge of environmental

pollutants Free speech laws Energy conserving requirements ……

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Policies Toward Pollution

Environmental standards - rules that protect the environment by specifying actions by producers and consumers.

Emissions tax - a (Pigouvian) tax designed to reduce external costs 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.

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Figure 12.3, P.322Taxing a Negative Externality

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Not necessarily zero

Socially optimal pollution:

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Why a Market Economy Produces Too Much Pollution

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Property Rights

People have the right to own any property they acquire by lawful means and to do with that property much as they see fit

Lack of property rights: not including marginal cost of resource use

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1 126 26 26 26

2 119 19 38 12

3 116 16 48 10

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

Marginal Income and theSocially Optimal Herd Size

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The Problem of Un-priced Resources

When no one owns the commons, the opportunity cost of using it is not considered.

Use of the commons will increase until MB = 0.

One person’s use of the commons imposes an external cost on the others by making the property less valuable.

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The Effect of Private Ownership

Assume– Villagers can borrow and lend at 13%.– The villagers decide to auction off the rights to the

commons.– One steer is the optimal number– Income from one steer = $26.– Pay $100 for the commons

• 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:• (4 x $13) + $26 = $78 or• (4 x $13) + $13 rent + $13 highest bidder = $78

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Observations

Common property is not used efficiently When the land is auctioned, the highest bidder will

have an incentive to consider the opportunity cost of grazing additional steers.

Private ownership may be impractical. The laws can also be used to achieve an individual

goal (reelection) by reducing the economic surplus. Zoning laws and other regulations restrict the use of

private property. The laws can be used to maximize economic surplus.

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Examples of Property Rights and Externalities

Blackberries in public parks Shared milkshakes Harvesting timber on remote public land Harvesting whales in international

waters Controlling multinational environmental

pollution

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Positional Externalities

When an increase in one person’s performance reduces the expected reward of another in situations in which reward depends on relative performance

Payoffs Depend on Relative Performance– In 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.• When the payoff depends on relative performance,

incentive to invest in performance activities will be excessive from a collective point of view.