Week 11: Externalities and Property Rights

Private Ownership

- Animal species valuable to humans but not privately owned are at the most disadvantage in terms of extinction. - Whales and elephants as opposed to chicken and pigs

Positional Arms Control Agreements

- Campaign Spending limits - Roster Limits - Major league baseball allows max of 25 players on the roster; basketball at 12 and football at 53. In their absence any team could increase their chance of winning by adding players and other teams would follow. Yet this would not increase the value of the game to society. Hence roster limits. - Arbitration agreements - parties often sign binding agreements committing to arbitration in the event of a dispute - Mandatory starting dates for kindergarten

The Coase Theorem: In the presence of externalities, if negotiations are costless.....

- Either those harmed will pay to stop pollution + Example - in the previous case B will have an incentive to pay A to stop pollution because the MB from stopping pollution to Firm B ($50) is greater than the MC of stopping pollution to Firm A ($30). - Or polluters will buy the rights to pollute + This will be the case if the MB to Firm A from polluting is greater than MC of the harm to Firm B. Which of these will happen depends on which is the least cost way of achieving the efficient solution.

How Externalities Affect Resource Allocation

- Externalities reduce economic efficiency. - We will see that when parties affected by the externalities can negotiate with one another, the invisible hand will still produce an efficient outcome. - But when such individual negotiations are not possible, government intervention or other collective action may be needed to reach an efficient solution.

Smart For One But Dumb For All A Darwinian explanation:

- Most vertebrates are polygynous (one male takes more than one mate). So males have to compete for access to females. - The winner bull seal will command nearly exclusive mating access to harems of as many as 100 females. - Other examples: large tail displays in peacocks; huge antlers in elks, etc. - Among monogamous species, like albatross, males and females tend to be similarly sized. - For both the large bull and the large tailed male peacock, what is advantageous to the individual is disadvantageous as a group. - A 6000 lbs seal finds it difficult to escape from a great white shark, it's principal predator. - If each bull could reduce its weight in half, each would be better off. The outcome of the fight would be the same as before but they would escape the shark attacks more easily. - But for now bull elephant seals are stuck with their massive sizes due to an evolutionary arms race of sorts. - Of course this evolutionary arms race settles down to an evolutionary equilibrium of MB=MC at some point. - Along the evolutionary road, the seals must have got just as big as to equate the MB of reproductive advantage to the MC of the unwieldiness due to size. - The current sizes of surviving bull and female seals reflects this equilibrium.

Social Norms as Positional Arms Control Agreements

- Nerd Norms - norms against studying too hard - Fashion and Taste Norms - norms against fashion that can be harmful to the individual - Norms against vanity - social norms against cosmetic enhancements

Positional Externalities

- Positional Externalities arise when - Payoffs depend on relative performance - highest compensation goes to the best performer + Standard is relative, not absolute - Each player increases spending to increase probability of winning + Sum of all these investments exceed the collective payoff + Total payout is fixed, so overall gain to the players' as a group from these additional investments is zero In a competitive situation: - When the payoff depends on relative performance, incentive to invest in performance enhancement activities will be excessive from a collective point of view.

Positional Arms Races and Positional Arms Control Agreements

- Positional Externality - Positional externalities occur when an increase in one person's performance reduces the expected reward of another - A positional arms race is a series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality - Positional arms control agreements are attempts to limit the mutually offsetting investments in performance enhancements by contestants - this is the reason why the govt. ban on cigarette advertising on TV increased profits of the cigarette companies.

A Pigouvian World

- Possibility 1: Direct Regulation. Government legally requires Firm A to operate with a filter. This will lead to efficiency. - Possibility 2: A Pigouvian tax of $30 on A, if it does not use the filter, will correct the externality. The government will have to know that the cost to Firm A imposed by the externality is $30. - Because in this case the ES using clean technology (with filter) is greater than traditional technology (without filter), a filter requirement will lead to efficiency.

Again, Phoebe harvests and sells honey from her bees - Phoebe's neighbors are an elementary school and a nursing home - The more bees Phoebe harvests the greater the number of people stung by bees - Phoebe does not have to pay for the nuisance How Externalities Affect Resource Allocation - Does the honeybee keeper face the right incentives?

- Private costs are equal to private benefits - Social costs are greater than social benefits 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.

Why Are Males Bigger Than Females?

- Some traits like intelligence serve individual and societal interests with no conflict. - Other traits like body weight, antler size, etc., serve individual interests but harm the larger group as a whole. - Why are males bigger than females in most vertebrate species? Answer: polygyny. - Bull elephant seals can exceed 20 ft in length and weight 6000 lbs (think Lincoln Navigator) whereas females weigh only 800 - 1200 lbs. - Similar dimorphism across gender is observed in most vertebrate species.

Arms Races

- The 3rd week of Nov each year is "Get Smart About Antibiotics Week" - a CDC sponsored event to enhance recognition of antibiotics resistance as a huge global public health crisis. - Alexander Fleming had cautioned us about the potential for bacteria to develop resistance to penicillin as a result of misuse during his Nobel acceptance speech (Nobel Prize in Physiology and Medicine) in 1945. - Sure enough - a strain of Staphylococcus Aureus was found to be resistant to Penicillin as early as 1947, just 4 years after antibiotics gained widespread usage. - Physicians reacted by prescribing an alternate antibiotic - Methicillin. But Methicillin-resistant bacteria (MRSA) were first discovered in the UK as early as 1961. - MRSA infections were responsible for 37% of fatal cases of blood poisoning in the UK in 1999, up 4% from 1991. - So, why then do physicians tend to overprescribe antibiotics? Don't they learn not to in Med school? - It is an arms race. Most physicians understand the dangers of antibiotic overuse. But they give in to patient demands in the fear that otherwise they will lose business to a doctor who will prescribe antibiotics

Coase Theorem Again

- The Coase theorem tells us that regardless of whether the law holds polluters liable for damages, the affected parties will achieve efficient solutions to the externalities if they can negotiate costlessly with one another - This does not imply that affected parties will be indifferent about whether the law holds polluters responsible or not. - If the law penalizes polluters, they will end up with lower economic surpluses and those injured by the polluters will enjoy higher economic surpluses

Coase Theorem says that when

- The existence of externalities does not necessarily lead to an inefficient equilibrium. - when property rights exist, are clear and enforceable, all economic agents have full information, transaction costs (of negotiations) are low, then - private individuals can always negotiate to achieve efficient solutions to problems caused by externalities - In such a case, imposition of a Pigouvian tax or a government ban may lead to inefficiency. - Coase's bottomline: The problem with externalities is not the externality itself but rather the existence of transaction costs in negotiations.

Externalities and 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. - 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.

Why do the villagers do better when they make their investment decisions collectively?

- When individuals decide alone, they ignore the fact that sending another cattle to graze onto the commons will cause existing cattle to gain less weight and hence become less valuable to everyone. - Grazing land on the commons is a valuable economic resource. When no one owns property, the opportunity cost of using it is not considered. (Use of the property will increase until MB = 0.)

Property Rights and The Tragedy of Commons

- Why do blueberries in public parks get picked too soon? - Why are shared milkshakes consumed too quickly? - Why are there no buffaloes but plenty of chickens? (animal species valuable to humans but not privately owned are often the most endangered) Tragedy of the commons is the tendency for a resource that has no price to be overused; i.e., used until its marginal benefit is pushed to zero

External Costs and Benefits

- With externalities, private market equilibrium is inefficient. There is cash on the table - Pigouvian taxes (in case of negative externalities) or subsidies (in case of positive externalities) can achieve efficiency. - So can direct regulations that control pollution. - The next several examples show how in the presence of externalities, and in the absence of Pigouvian intervention, actions to capture the surplus are likely. In some cases, a Pigouvian tax or subsidy may be surplus reducing!

internalizing externalities (Pigouvian Taxes/subsidies)

- to remedy the problem, "internalize the externality" -tax good with negative externalities (higher price lower output) -subsidize goods with positive externalities (lower price higher output) Taxes -per-unit taxes increase the marginal cost for a firm and shifts all cost curves upward and decrease the quantity to be produced -Impact of lump-sum tax: no effect as this tax only changes the fixed costs and thus the firm will continuee to produce the same Q -subsidies: per-unit subsidies shift the MC curve down, encouraging a greater Q to be produced -treat taxes and subsidies as incentives. Taxes decrease output and subsidies increase output

analysis of a negative externality

-Marginal Social Cost (MSC)= private + external cost (second supply curve above MPC curve (MSC>MPC) where we add the external cost of producing gasoline to the private cost of producing gasoline) -Supply=MPC (cost incurred by gasoline producers) -external cost=value of the negative impact on bystanders -ex: we're going to say the external cost of gasoline= $1 per gallon (value of harm from smog, greenhouse gases) -D=MSB=MPB curve (no external benefits, so MSB=MPB) -free market produces where MPB=MPC -socially optimal Q is where MSB=MSC -in this market failure, market is producing a greater quantity than what society wants it to produce (producing too much) -DWL is the external cost to society and the overproduction/overallocation at the expense of society. This is above the Demand Curve from the Q of the free market to the Q of SO and it's above the D curve - Social MC = Private MC + XC

examples of positive externalities

-People going to college raise the population's education level, which reduces crime and improves government -good hygiene -community artwork -planting trees

analysis of a positive externality

-S=MSC curve (only one supply curve and this means S=MSC=MPC) -MPB curve, but we know there is also an external benefit (value of the positive impact on bystanders)= $10/flu shot -so, add on the benefit to the MPB curve= Marginal Social Benefit (MSB) curve -MSB curve= private value + $10 external benefit -MSB>MPB -free market going to produce where MPB = MPC -socially optimal quantity will be where MSB=MSC -market is inefficient and produces less than what society wants it to produce (market failure) -DWL is the under allocation of flue shots -DWL is between the market Q and SO Q and it is to the left of your equilibrium (above the supply (MSC=MPC) curve)

Market Failure

-a situation in which the free-market system fails to satisfy society's wants 1. monopolies (P>MC, produce less than socially optimal Q) 2. income inequality (based on values of resources you own, progressive taxes) 3. externalities 4. public goods -in each of these situations, the gov steps in to allocate resources more efficiently

externality

-a situation where some of the costs or benefits from an activity fall on someone other than the people directly involved in the activity -aka spillover costs/benefits and third party costs/benefits

The Coase Theorem

-even when have externality, don't have to run to the gov and have them fix it- you could do it yourself -ronald coase argued that private parties could negotiate themselves to reduce the misallocation of resources -the party who bears the social cost can pay the producer to not produce. This payment must be greater than the producer's marginal benefit forgone. (need to determine the value of good to both parties and then negotiate and sum of payment that benefits both parties) -this solution requires two conditions: 1. clearly defined property rights (who has right to ownership?) -doesn't matter who has property rights, as long as somebody does 2. parties need to be able to negotiate payments and expect that contracts are enforceable (need to be sure seller is going to abide by the contract and that payment is actually going to solve the problem)

graphing an externality

-focus on perfect competition (many sellers, many buyers) -if no externality, normal S and D curves (only two) -supply curve shows marginal private cost (MPC), the costs directly incurred by sellers. -if there is no externality, MPC=MSC (marginal social cost) (only one curve) -Demand curve shows marginal private benefit (MPB) (value to buyers), downward sloping bc of diminishing marginal utility with consumption of each additional unit of good -if there is not externality, MPB=MSB (marginal social benefit) (only one curve) -private decision makers produce where MPB=MPC -society wants a market to produce where MSB=MSC (to take into account the external costs and benefits to society)

internalizing a negative externality

-internalizing the externality: altering incentives so that people take account of the external effects of their actions -can do this by imposing tax on seller equal to the cost of the externality -make MPC=MSC -tax sellers $1 (aka Pigouvian tax) if the external cost is $1 which pushes MPC up so that MPC=MSC -this means that the market is producing the socially optimal quantity bc there is a new equilibrium -when market participants must pay social costs, market equilibrium=social optimum -taxing buyers/comsumers $1 would also correct the externality by shifting D curve to the left and then create new equilibrium where you can achieve the socially optimum quantity (make consumers less willing to consume)

internalizing a positive externality

-make MPB=MSB through a subsidy -want to incentivize private decision makers to think of the benefits of other people -give buyers a $10 subsidy if the external benefit is $10 (aka Pigouvian subsidy) which pushes MPB up to MSB -now free market Q = social optimum Q -when market participants must pay social costs, market equilibrium=social optimum -giving sellers a $10 subsidy would also correct the externality (supply curve shifts to the right, and new equilibrium is where Free market Q= SO Q - Without external benefits QPVT is the social optimum - With external benefits the private D < social D and the private optimum is less than the social optimum - Social MB = Private MB + XB

imperfect competition negative externality

-monopoly: downward sloping D curve and MR curve below D -then MSC>MPC (negative externality) -monopolist's profit maximizing P and Q (MR=MC(=MPC)) because monopolist only thinks about their own private cost -socially optimal Q is where MSB (D) =MSC and P is where that Q goes to the D curve -the gov needs to subsidize in order to shift MPC down (not tax because if you tax the firm then you move MPC up to MSC but if you do that then MR=MC intersection will be where MR=MSC and that means the firm is not producing a socially optimal quantity because this is less than what society want it to produce, you want the MR=MC intersection at the Q where MSC=D and use the D curve to set the price) -use THEORY not LOGIC

key points

-private decision makers produce where MPB=MPC -society wants a market to produce where MSB=MSC -as long as MEB and MEC are zero, the market quantity will be the socially optimal quantity -if MEB and/or MEC is not zero, we have a market failure -negative externality- market quantity larger than socially desirable -positive externality- market quantity smaller than socially desirable

positive externalities

-situations that result in a benefit for someone other than the original decision maker -ex: flu vaccines -I got a flu shot this last week...why? bc I personally didn't want to get sick (but there is an external benefit to that decision) -by getting a flu shot, I am less likely to get the flu and thus less likely to spread it to people around me (positive externality) -the gov recognizes external benefits of vaccinations and often holds free flu shot clinics - Without external benefits QPVT is the social optimum - With external benefits the private D < social D and the private optimum is less than the social optimum - Social demand = Private Demand + XB

negative externalities

-situations that results in a cost for a different person other than the original decision maker -ex: plastic bags 1. 100 billion plastic bags are used by Americans every year (we use plastic bags for our own benefit but ignore their harmful effects on the environment) negative externality: 1. plastic bags are very harmful and it takes over 500 years for them to decompose and harms wildlife -gov recognizes the external costs and makes policies to limit the use of plastic bags (make consumers pay for bags...$0.10 per bag)

why are externalities market failures?

-the free market fails to include external costs or external benefits -when making a decision, making a decision on my behalf not thinking about it hurts or benefits people around me -bc only thinking about me, there is a change that the free market will produce too much or too little of a good bc not taking in external costs or benefits -without government involvement, there would be too much or too little produced

A and B are considering living alone or being roommates and splitting the rent for the next twelve months. A one bedroom, one bath apartment is $500 per month while a two bedroom, one bath apartment is $800. The one difficulty they have is that B snores very loudly. A estimates the cost of poor sleep due to B's snoring at $150 per month. B could obtain a snore-eliminating device for $50 per month. 1) The least costly solution to the externality present in this situation is for 2) The actual monthly gain in surplus to A and B from living together after addressing the snoring problems in the least costly way is 3) If they share the surplus equally, B's share of the rent will be _____________ and A's share of the rent rent will be _____________.

1) A to eliminate B's snoring. 2) $150. 3) $375; $425

Is Check Splitting Efficient? You and 9 other friends are dining together and have decided to split the bill equally. You know you want prime rib. A regular serving costs $30 and a large serving costs $40. Your additional benefit for the larger size is $5. 1) If you had to pay for your dinner, would you order the larger size? 2) If you are splitting the bill, will you order the larger size? 3) Is check splitting socially efficient?

1) No, because the MB ($5) is less than the MC ($10). 2) Yes, because your MB remains $5 but your MC is now $1 (1/10th of $10). 3) No, because the additional gain in your surplus ($4 = 5 - 1) is less than the cost ($9) to the rest of the group.

Early settlers in the town of DryValley drilled wells to pump as much water as they wanted from the single aquifer beneath the town. (An aquifer is an underground body of water.) As more people settled in DryValley, the aquifer level fell and new wells had to be drilled deeper at higher cost. 1) The aquifer beneath DryValley is 2) Residents of DryValley have a private incentive to _____________ water because _____________ 3) The town council has proposed putting a meter on each household's pump, and charging residents for each gallon of water used. This would

1) a commons 2) over use; external costs aren't considered. 3) price an un-priced resource, increasing incentives to avoid wasting water.

Taylor lives in a residential neighborhood that prides itself on well-groomed lawns. Taylor's neighbors find that the collective marginal benefit of someone else's well-groomed lawn is $10. Taylor, however, dislikes yard-work and receives zero net benefit from an unkempt lawn and a net benefit of -$1 for a well-groomed lawn - the cost of maintaining the lawn for him is a dollar more than the benefit of having a well-groomed lawn. 1) The issue of Taylor, his neighbors, and the state of his lawn is an example of a(n) 2) If Taylor acts independently, Taylor's lawn will be _____________and total economic surplus to the neighborhood will be _____________. 3) If Taylor's lawn is unkempt, the situation is _____________because the total economic surplus is _____________. 4) . Taylor's neighbors would be willing to pay Taylor _____________to keep a well groomed lawn 5) If Taylor's neighbors pay Taylor $5 to maintain his lawn, Taylor will have a net benefit of _____________ and the neighbors will have a net benefit of _____________.

1) externality. 2) unkempt; 0 3) inefficient; smaller than it could have been 4) no more than $10. 5) +$4; +$5

examples of negative externalities

1. air pollution from a factory 2. the neighbor's barking dog 3. late-night music blasting from the dorm room next to yours 4. noise pollution from construction projects 5. health risk to others from second-hand smoke 6. talking on cell phone while driving makes the roads less safe for others

Why private solutions do not always work

1. transaction costs are too high: the cost parties incur in the process of agreeing to and following through on a bargain (the use of a lawyer). Working together not easy, both oppositional people so need a lawyer which increase the transaction costs. These make it less likely a solution will be missed and the costs may make it impossible to reach a mutually beneficial agreement. 2. coordination problems: if the number of parties is very large, coordinating them may be costly, difficult, or impossible because everyone has different interests 3. stubbornness: even if a beneficial agreement is possible, each party may hold out for a better deal that the other person is not willing to pay

External Benefit (positive externality)

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

External Cost (negative externality)

A cost of an activity that falls on people other than those who pursue the activity

Understanding Coase Theorem requires us to realize that

An external cost is not simply a cost produced by the polluter and borne by the victim. It is reciprocal - Firm A would not hurt Firm B if it did not pollute - Firm B would not be hurt by Firm A if it did not locate downstream from A.

The major implication of the _____________ is that individuals can solve many externalities if they can buy and sell the right to generate the externality.

Coase Theorem

ex of coase theorem

Jack owns a dog named Spot -negative externality : Spot's barking disturbs Jane, Jack's neighbor and she can't sleep Solution? 1. figure out value of Spot 2. figure out value of peace and quiet -doesn't matter who has property rights, as long as somebody does Case 1: property rights says that Jack has the right to have Spot -benefit to Jack of having Spot= $500 -cost to Jane of Spot's barking (value of peace and quiet) = $800 ***Private outcome (negotiate a sum of payment that makes most of them happy) -Jack wants at least $500 and Jane will pay up to $800 -any value between those amounts will make both happy -Jane pays Jack $600 to get rid of Spot, both Jane and Jack are better off Case 2: Jane has the property/legal right to peace and quiet -Benefit to Jack of having Spot= $800 -Cost to Jane of Spot's barking=$500 ***private outcome:(Jack pays Jane bc Jane has property rights) Jack pays Jane $600 to put up with Spot's barking (any amount between 500 and 800 makes both parties happy) -negative externality but didn't need police or gov intervention and these two people worked it out on their own and the private market achieves the efficient outcome regardless of the initial distribution of rights

Why do football players take anabolic steroids? - Smith and Jones are competing for a single position and a $10 million contract. If both take steroids or both don't take steroids, each has a 50% chance of winning.

Payoff Matrix for Steroid Consumption - Prisoner's Dilemma - Dominant strategy for each yields the third best outcome - This prisoner's dilemma outcome is why rules banning performance enhancing drugs increases economic efficiency.

Phoebe harvests and sells honey from her bees - Bees pollinate the neighboring apple orchards - No payments are made to Phoebe - The bees provide a free service to the local farmers How Externalities Affect Resource Allocation - Does the honeybee keeper face the right incentives?

Phoebe is giving away a service - Private costs are equal to private benefits - Social costs are less than social benefits 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.

Consider the case of airport noise.

Solution 1: Reduce airport noise (standard argument of hold the polluter responsible) Solution 2: Soundproof neighboring houses Solution 3: Use the land around airports to build factories (who will not mind the noise) rather than residential housing. - Is the residential developer/landowner the victim because he is unable to sleep with the noise of jets raging overhead? - Or is it the airport? Forced by a court to reduce noise, it has had to take expensive sound control measures in order to protect the sleep of people who built houses directly under the airport's flight path?

The Effect of Private Ownership

There are many laws that are aimed at increasing the economic surplus from public property by restricting their use - Zoning laws and other regulations restrict the use of private property. - Sometimes establishing property rights on all public property may not be practical. - Harvesting timber on remote public land - Harvesting whales in international waters. + How do you define property rights on whales? The behavior of whalers is hard to monitor, especially on international waters. - Controlling multinational environmental pollution. - International property rights.

Legal Remedies for Externalities

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 (Betty as opposed to Ann) When negotiation is not costless: - Laws or social norms may be used to correct for externalities. - The burden of the law is typically placed on those who have the lowest cost. - Many laws are created to help achieve solutions to externalities when parties are unable to negotiate with one another. +Speed limits and traffic laws + Municipal ordinances to limit noise + Limitations to discharge pollutants into the environment + Zoning laws + Free speech laws + Gun laws (or lack of it)

According to the textbook, limits on private property rights, e.g., zoning laws, are

an attempt to protect or enlarge the total economic surplus.

Laws that regulate the behavior of firms and of individuals are often enacted in order to

correct resource misallocation due to externalities.

If the external benefit of an activity is added to the private benefits, then the

demand curve shifts right.

taxes/subsidies

lump sum tax/subsidy -one time fee/grant -can produce as many units as you want, but gov will only tax/give you a fixed amount -this causes your AFC to shift upward (tax)/downward (subsidy) and then ATC will shift upward (tax)/downward (subsidy) -Q produced will remain the same since there was no shift to the MC curve. Market failure persists! per-unit tax/subsidy -a tax/subsidy on every unit that is produced -change your AVC and MC curve upward (tax)/downward (subsidy) -Q produced will decrease since MC curve shifted up -market failure corrected -only way to fix externalities is through a per-unit tax because that is the only way to change production quantities

The tragedy of the commons refers to the

overuse of resources that have no price.

If the market equilibrium quantity is greater than the socially optimal quantity, one can infer that

the production of this good has a negative externality.

If the market equilibrium quantity is less than the socially optimal quantity, one can infer that

the production of this good has a positive externality.

A resource that has common property rights is one that

treated as though it has a price of zero.

The Optimal Amount of Negative Externalities is Not Zero

where MC is the upward sloping supply curve (increasing opportunity cost) and MB is the downward sloping demand curve (diminishing marginal utility) the optimal amount of pollution is MC=MB