11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 12: Ch. 12: Externalities and Property Rights

22

External Costs and BenefitsExternal Costs and Benefits

External Cost (negative externality)External Cost (negative externality)A cost of an activity that falls on people other A cost of an activity that falls on people other

than those who pursue the activitythan those who pursue the activityExternal Benefit (positive externality)External Benefit (positive externality)

A benefit of an activity received by people A benefit of an activity received by people other than those who pursue the activityother than those who pursue the activity

33

External Costs and BenefitsExternal Costs and Benefits

How Externalities Affect Resource How Externalities Affect Resource AllocationAllocationExternalities reduce economic efficiency.Externalities reduce economic efficiency.Solutions of externalities may be efficient.Solutions of externalities may be efficient.When efficient solutions to externalities are When efficient solutions to externalities are

not possible, government intervention or not possible, government intervention or other collective action may be used.other collective action may be used.

44

How Externalities Affect How Externalities Affect Resource AllocationResource Allocation

Does the honeybee keeper face the right Does the honeybee keeper face the right incentives? (Part I)incentives? (Part I)Bees pollinate the apple orchards.Bees pollinate the apple orchards.The honeybee keeper may not consider the The honeybee keeper may not consider the

external benefit to the apple growers when external benefit to the apple growers when considering the optimal number of hives.considering the optimal number of hives.

If the external benefit is not considered, the If the external benefit is not considered, the bee keeper’s optimal number of hives will be bee keeper’s optimal number of hives will be less than the socially optimal number of hives.less than the socially optimal number of hives.

55

How Externalities Affect How Externalities Affect Resource AllocationResource Allocation

Does the honeybee keeper face the right Does the honeybee keeper face the right incentives? (Part II)incentives? (Part II) If the hives are located near a school and nursing If the hives are located near a school and nursing

home, additional hives will cause more people to get home, additional hives will cause more people to get stung by the bees.stung by the bees.

For the students and nursing home residents, the bee For the students and nursing home residents, the bee hives create an external cost.hives create an external cost.

If the external costs are not considered, the optimal If the external costs are not considered, the optimal number of hives for the beekeeper will be greater than number of hives for the beekeeper will be greater than the socially optimal number of hives.the socially optimal number of hives.

66

How Externalities Affect How Externalities Affect Resource AllocationResource Allocation

When an activity does not create an When an activity does not create an externality, the optimal level of the activity for externality, the optimal level of the activity for the individual will equal the socially optimal the individual will equal the socially optimal level of the activity.level of the activity.

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

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

77

How External Costs How External Costs Affect Resource AllocationAffect Resource Allocation

Pri

ce (

$/to

n)

Quantity (tons/year)

Pri

ce (

$/to

n)

Quantity (tons/year)

Production without external cost Production with external cost

DD

Private MC

12,000

1,300Private MC

12,000

1,300

Privateequilibrium

Deadweight loss caused bypollution = $2mil/yr

2,000

8,000Social

optimum

2,300 XC = $1,000/ton

Social MC =Private MC + XC

88

A Good Whose Production Generates a A Good Whose Production Generates a Positive Externality for ConsumersPositive Externality for Consumers

Pri

ce

Quantity

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

Deadweight loss frompositive externality

Private Demand

MC

Qpvt

MBPVT

• Without external benefits QPVT is the social optimum

99

Costs and Benefits of Costs and Benefits of Eliminating Toxic WasteEliminating Toxic Waste

$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

Assume Fitch and Abercrombie can communicate at no costFitch offers Abercrombie $40 to use the filterEconomic surplus increases by $20

1010

The Coase TheoremThe Coase Theorem

When a market leaves cash on table there When a market leaves cash on table there is usually a response to capture the is usually a response to capture the unrealized value.unrealized value.

1111

The Coase TheoremThe Coase Theorem

If at no cost people can negotiate the If at no cost people can negotiate the purchase and sale of the right to perform purchase and sale of the right to perform activities that cause externalities, they can activities that cause externalities, they can always arrive at efficient solutions to always arrive at efficient solutions to problems caused by externalities.problems caused by externalities.

1212

ExampleExample

By law Abercrombie cannot dump without By law Abercrombie cannot dump without Fitch’s approval.Fitch’s approval.

Fitch and Abercrombie can negotiate Fitch and Abercrombie can negotiate without cost.without cost.

1313

Costs and Benefits of Costs and Benefits of Eliminating Toxic WasteEliminating Toxic Waste

$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

1414

Legal Remedies for ExternalitiesLegal Remedies for Externalities

When negotiation is costless:When negotiation is costless:Efficient solutions to externalities can be Efficient solutions to externalities can be

found.found.The adjustment to the externality is usually The adjustment to the externality is usually

done by the party with the lowest cost.done by the party with the lowest cost.When negotiation is not costless:When negotiation is not costless:

Laws may be used to correct for externalities.Laws may be used to correct for externalities.The burden of the law can be placed on those The burden of the law can be placed on those

who have the lowest cost.who have the lowest cost.

1515

The Optimal Amount of Negative The Optimal Amount of Negative Externalities is Not ZeroExternalities is Not Zero

Quantity of Pollution abated

MC/MB

MC (increasing opportunity cost)

Q

MC = MB

MB (diminishing marginal utility)

Optimal amount of pollution: MC = MB

Pollution freeDirty environment

1616

Taxing a Negative ExternalityTaxing a Negative ExternalityP

rice

($/

ton

)

Quantity (tons/year)

Pri

ce (

$/to

n)

Quantity (tons/year)

DD

Private MC1,300

Private MC

12,000

1,300

Private equilibriumwithout pollution tax

2,000

8,000

Tax = $1,000/ton

Private MC + TaxSocial MC = Private MC + XC

XC = $1,000/ton2,000

2,300

8,000Social

optimum

12,000Privateequilibrium

Private equilibriumwith pollution tax

1717

Subsidizing a Positive ExternalitySubsidizing a Positive ExternalityP

rice

($/

ton

)

Quantity (tons/year)Quantity (tons/year)

Private demand

Social demand = Private demand + XB8

Private equilibriumwithout subsidy

MC

10

14

1,200 1,600

Socialoptimum

XB = 6

Private demand

MC

Private equilibrium with subsidy

Subsidy = 6

1,200 1,600

Subsidized demand =Private demand + subsidy

8

10

14

1818

Tragedy of CommonsTragedy of CommonsThe Problem of “Free” ResourcesThe Problem of “Free” Resources

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

Use of the property will increase until Use of the property will increase until MBMB = 0. = 0.One person’s use of the commons imposes One person’s use of the commons imposes

an external cost on the others by making the an external cost on the others by making the property less valuable.property less valuable.

If the common property is privatized If the common property is privatized (auctioned) opportunity cost of additional use (auctioned) opportunity cost of additional use will be considered by the ownerwill be considered by the owner

1919

Tragedy of CommonsTragedy of CommonsThe Effect of Private OwnershipThe Effect of Private Ownership

Zoning laws and other regulations restrict the Zoning laws and other regulations restrict the use of private property.use of private property.

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

The laws can also be used to achieve an The laws can also be used to achieve an individual goal (reelection) by reducing the individual goal (reelection) by reducing the economic surplus.economic surplus.

Private ownership may be impractical Private ownership may be impractical because MB<MC.because MB<MC.

2020

Positional ExternalityPositional Externality When an increase in one person’s performance When an increase in one person’s performance

reduces the expected reward of another in reduces the expected reward of another in situations in which reward depends on relative situations in which reward depends on relative performanceperformance

In a competitive situation:In a competitive situation: There is an incentive to take an action to increase the There is an incentive to take an action to increase the

odds of winning.odds of winning. The overall gain to the players as a group will be zero.The overall gain to the players as a group will be zero. When the payoff depends on relative performance, When the payoff depends on relative performance,

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

2121

Payoff Matrix forPayoff Matrix forSteroid ConsumptionSteroid Consumption

Second best for eachBest for Jones

Worst for Smith

Best for Smith

Worst for JonesThird best for each

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.

2222

Positional Arms RacePositional Arms Race

A series of mutually offsetting investments A series of mutually offsetting investments in performance enhancement that is in performance enhancement that is stimulated by a positional externalitystimulated by a positional externality

Positional Arms Control AgreementsPositional Arms Control AgreementsAn agreement in which contestants attempt to An agreement in which contestants attempt to

limit mutually offsetting investments in limit mutually offsetting investments in performance enhancementsperformance enhancements