Mircoeconomics Ch 11

The auction method has the same virtue as the tax method: It concentrates pollution reduction in the hands of those firms that can accomplish it at the lowest cost. But the auction method has other attractive features that the tax approach does not. First, it does not induce firms to commit themselves to costly investments that they will have to abandon if the cleanup falls short of the target level. And second, it allows private citizens a direct voice in determining where the emission level will be set. For example, any group that believes the pollution target is too lenient could raise money to buy permits at auction. By keeping those permits locked away in a safe, the group could ensure that they will not be used to emit pollution. Several decades ago, when economists first proposed the auctioning of pollution permits, reactions of outrage were widely reported in the press. Most of those reactions amounted to the charge that the proposal would "permit rich firms to pollute to their hearts' content." Such an assertion betrays a total misunderstanding of the forces that generate pollution. Firms pollute not because they want to pollute but because dirty production processes are cheaper than clean ones. Society's only real interest is in keeping the total amount of pollution from becoming excessive, not in who actually does the polluting. And in any event, the firms that do most of the polluting under an auction system will not be rich firms, but those for whom pollution reduction is most costly. Economists have argued patiently against these misinformed objections to the auction system, and their efforts have finally borne fruit. The sale of pollution permits is now common in several parts of the United States, and there is growing interest in the approach in other countries.

CLIMATE CHANGE AND CARBON TAXES Growing concentrations of carbon dioxide (CO2) in the atmosphere are widely believed to be a principal contributor to global warming. Concerns about the consequences of climate change have led to proposals to tax (CO2) emissions or require marketable permits for them. Critics of these proposals emphasize that forecasts involving climate change are highly uncertain, a fact they view as arguing against taking action. But uncertainty is a two-edged sword. Climate researchers themselves readily concede that estimates based on their models are extremely uncertain. But that means that although the actual outcome might be much better than their median forecast, it might also be significantly worse. Organizers of the 2009 climate conference in Copenhagen sought to limit global warming to 3.6°F by the end of the twenty-first century. But even an increase that small would cause deadly harm, and the most respected climate change models estimate that there is essentially no chance that average temperature will rise by less than that amount if we take no action. According to estimates published in 2013 by the Intergovernmental Panel on Climate Change (IPCC), the median forecast is for an average global temperature climb of 6.7°F by century's end, in the absence of effective countermeasures.2 The IPCC also estimated that we face a 5 percent chance of temperatures rising by more than 8.6°F by 2100. Temperature increases of that magnitude would be accompanied by sea level rises that would make much of the world's most densely populated coastal regions uninhabitable. Climate scientists also believe that severe storms and droughts caused by climate change are already causing enormous damage.3 Again, long-term forecasts from climate models are highly uncertain. Things might not be as bad as predicted. But they could also be much worse. In other domains, uncertainty doesn't counsel against taking action. Few would recommend, for example, that we disband the military simply because adversaries might not invade. In the climate arena, the only remaining uncertainty is how much worse things will get. Should we take action? To respond to that question, we must ask, how much would it cost? The answer, as it turns out, is astonishingly little.

THE OPTIMAL AMOUNT OF NEGATIVE EXTERNALITIES IS NOT ZERO Increasing Opportunity Cost --> Curbing pollution and other negative externalities entails both costs and benefits. As we saw in Chapter 6, Perfectly Competitive Supply, when we analyzed how many cans should be recycled, the best policy is to curtail pollution until the cost of further abatement just equals the marginal benefit. In general, the marginal cost of abatement rises with the amount of pollution eliminated. (Following the Low-Hanging-Fruit Principle, polluters use the cheapest cleanup methods first and then turn to more expensive ones.) And the law of diminishing marginal utility suggests that beyond some point, the marginal benefit of pollution reduction tends to fall as more pollution is removed. As a result, the marginal cost and marginal benefit curves almost always intersect at less than the maximum amount of pollution reduction. The intersection of the two curves marks the socially optimal level of pollution reduction. If pollution is curtailed by any less than that amount, society will gain more than it will lose by pushing the cleanup effort a little further. But if regulators push beyond the point at which the marginal cost and benefit curves intersect, society will incur costs that exceed the benefits. The existence of a socially optimal level of pollution reduction implies the existence of a socially optimal level of pollution, and that level will almost always be greater than zero. Because people have been conditioned to think of pollution as bad, many cringe when they hear the phrase "socially optimal level of pollution." How can any positive level of pollution be socially optimal? But to speak of a socially optimal level of pollution is not the same as saying that pollution is good. It is merely to recognize that society has an interest in cleaning up the environment, but only up to a certain point. The underlying idea is no different from the idea of an optimal level of dirt in an apartment. After all, even if you spent the whole day, every day, vacuuming your apartment, there would be some dirt left in it. And because you have better things to do than vacuum all day, you probably tolerate substantially more than the minimal amount of dirt. A dirty apartment is not good, nor is pollution in the air you breathe. But in both cases, the cleanup effort should be expanded only until the marginal benefit equals the marginal cost.

COMPENSATORY TAXES AND SUBSIDIES As noted, when transaction costs prohibit negotiation among affected parties, negative externalities lead to excessive output levels because activities that produce negative externalities are misleadingly attractive to those who engage in them. One solution to this problem, proposed by the British economist A. C. Pigou, is to make such activities less attractive by taxing them. Figure 11.3(a) reproduces Figure 11.1's portrayal of a market in which each unit of output generates an external cost of XC equal to $1,000 per ton. Because producers fail to take this external cost into account, the private equilibrium is 12,000 tons per year, or 4,000 tons per year more than the socially optimal level of 8,000 tons per year.

EXAMPLE 11.4 Negotiating Efficient Solutions to Externalities Will Abercrombie dump toxins in the river? (Part 2) Suppose the costs and benefits of using the filter are as in the previous example except that Abercrombie and Fitch can now communicate with one another at no cost. Even though the law does not require him to do so, will Abercrombie use a filter? Efficiency This time, Abercrombie will use a filter. Recall from Chapter 7, Efficiency, Exchange, and the Invisible Hand, the observation that when the economic pie grows larger, everyone can have a larger slice (the Efficiency Principle). Because use of a filter would result in the largest possible economic surplus, it would enable both Abercrombie and Fitch to have a larger net gain than before. Fitch thus has an incentive to pay Abercrombie to use a filter. Suppose, for instance, that Fitch offers Abercrombie $40 per day to compensate him for operating with a filter. Both Abercrombie and Fitch will then be exactly $10 per day better off than before, for a total daily net gain of $20.

CONCEPT CHECK 11.1 In Example 11.4, what is the largest whole-dollar amount by which Fitch could compensate Abercrombie for operating with a filter and still be better off than before? Ronald Coase, a professor at the University of Chicago Law School, was the first to see clearly that if people can negotiate with one another at no cost over the right to perform activities that cause externalities, they will always arrive at an efficient solution. This insight, which is often called the Coase theorem, is a profoundly important idea, for which Coase (rhymes with "rose") was awarded the 1991 Nobel Prize in Economics. Why, you might ask, should Fitch pay Abercrombie to filter out toxins that would not be there in the first place if not for Abercrombie's factory? The rhetorical force of this question is undeniable. Yet Coase points out that externalities are reciprocal in nature. The toxins do harm Fitch, to be sure, but preventing Abercrombie from emitting them would penalize Abercrombie, by exactly $30 per day. Why should Fitch necessarily have the right to harm Abercrombie? Indeed, as the next example illustrates, even if Fitch had that right, he would exercise it only if filtering the toxins proved the most efficient outcome.

This means that society could gain additional economic surplus by producing fewer units of the product. Indeed, the same conclusion will continue to hold whenever the current output exceeds 8,000 tons per year, the output level at which the demand curve intersects Social MC. Social MC, which includes all relevant marginal costs of producing the product, is constructed by adding the external pollution cost, XC, to every value along Private MC. The socially optimal level of output of the good occurs where Social MC intersects the demand curve. As shown in Figure 11.1(b), it is 8,000 tons per year. This is the level of output that exhausts all possibilities from exchange. At that quantity, the marginal benefit of the product, as measured by what buyers are willing to pay for it, is exactly equal to the marginal cost of producing it, which is the private marginal cost MC plus the marginal pollution cost XC. The market equilibrium quantity thus will be higher than the socially optimal quantity for a good whose production generates external costs. By how much does the presence of pollution reduce total economic surplus from its maximum value, which occurs at an output level of 8,000 tons per year in Figure 11.1(b)? Note in the diagram that as output expands past 8,000, the marginal cost of each successive unit (as measured on the Social MC curve) is greater than the marginal benefit of that unit (as measured on the demand curve). Expanding output from 8,000 tons per year to the private equilibrium level, 12,000 tons per year, thus entails a cumulative reduction in total economic surplus equal to the area of the blue-shaded triangle in Figure 11.1(b), or $2 million per year. The deadweight loss from pollution is $2 million per year in this market. What about a good whose production generates external benefits? In Figure 11.2, Private demand is the demand curve for a product whose production generates an external benefit of XB per unit. The market equilibrium quantity of this good, Qpvt, is the output level at which Private demand intersects the supply curve of the product (MC). This time, market equilibrium quantity is smaller than the socially optimal level of output, denoted Qsoc. Qsoc is the output level at which MC intersects the socially optimal demand curve (the curve labeled Social demand in Figure 11.2), which is constructed by adding the external benefit, XB, to every value along Private demand. Note that the private market equilibrium again fails to exhaust all possible gains from exchange. Thus, at Qpvt, the marginal cost of producing an additional unit of output is only MBpvt, which is smaller than the marginal benefit of an additional unit by the amount XB. The market equilibrium quantity thus will be lower than the socially optimal quantity for a good whose production generates external benefits.

(FIGURE 11.2 A Good Whose Production Generates a Positive Externality for Consumers. For such goods, the market equilibrium quantity, Qpvt, is smaller than the socially optimal quantity, Qsoc, because individual buyers are willing to pay only for the benefits they reap from directly consuming the product. The deadweight loss from the positive externality is the area of the blue-shaded triangle.) In comparison with the maximum attainable total economic surplus in this market, how much does the total economic surplus associated with the private equilibrium fall short? In Figure 11.2, note that at Qpvt, the marginal benefit of the product (as measured on the curve labeled Social demand) is XB units larger than its marginal cost (as measured on MC). Total economic surplus will continue to increase by successively smaller increments as output grows from Qpvt to Qsoc, the socially optimal quantity. The total deadweight loss associated with the positive externality is thus the area of the blue-shaded triangle in Figure 11.2. If the production of a product generates a positive externality, why do we say that this product causes a reduction in total economic surplus? To say that there is a deadweight loss in this market does not mean that the positive externality causes harm. Rather, it means that failure to take the positive externality into account makes the economic surplus associated with private equilibrium smaller than it could have been. Failure to reap an economic benefit is the same thing as sustaining an economic loss.Page 297 To summarize, whether externalities are positive or negative, they distort the allocation of resources in otherwise efficient markets. When externalities are present, the individual pursuit of self-interest will not result in the largest possible economic surplus. This outcome is thus inefficient by definition.

(FIGURE 11.3 Taxing a Negative Externality. (a) Negative externalities lead to an equilibrium with more than the socially optimal level of output. (b) Imposing a tax equal to the external cost leads to an equilibrium in which the output level is socially optimal. The tax makes the economy more efficient because it leads producers to take account of a relevant cost that they would otherwise ignore.) Figure 11.3(b) portrays that same market after the imposition of a tax of $1,000 per unit of output. This tax has the effect of raising each producer's marginal cost curve by $1,000, so the industry supply curve shifts upward by $1,000 at every quantity. Note that the resulting private equilibrium output, 8,000 tons per year, is now exactly equal to the socially optimal output. Although many critics insist that taxes always reduce economic efficiency, here we have an example of a tax that actually makes the economy Page 305more efficient. The tax has that effect because it forces producers to take explicit account of the fact that each additional unit of output they produce imposes an external cost of $1,000 on the rest of society. Similar reasoning suggests that a subsidy to producers can serve to counteract misallocations that result from positive externalities. Figure 11.4(a) portrays a market in which each unit of output generates an external benefit XB = $6 per ton. In this market, the socially optimal output level occurs at the intersection of the supply curve (MC) and the Social demand curve, which is constructed by adding XB = $6 per ton to the height of Private demand at each level of output. The socially optimal level of output is thus 1,600 tons per year. But private equilibrium in this market will occur at the intersection of Private demand and MC, which means that the equilibrium output, 1,200 tons per year, falls short of the social optimum by 400 tons per year.

(FIGURE 11.4 Subsidizing a Positive Externality. (a) Positive externalities lead to an equilibrium with less than the socially optimal level of output. (b) Paying producers a subsidy equal to the external benefit of the activity leads to an equilibrium in which the output level is socially optimal. The subsidy makes the economy more efficient because it leads producers to take account of a relevant benefit that they would otherwise ignore.) Figure 11.4(b) shows the effect of paying a subsidy to producers of $6 per ton, the amount of the external benefit. In the presence of this subsidy, the new private equilibrium is 1,600 tons per year, exactly the socially optimal level. The subsidy makes the economy more efficient because it induces producers to take account of a relevant benefit that they otherwise would have ignored.

EXAMPLE 11.7 Cost-Benefit Principle—Paying Unequal Rent Amounts What is the highest rent Betty would be willing to pay for the two-bedroom apartment? In Example 11.6, Betty's alternative is to live alone, which would mean paying $400 per month, her reservation price for a living arrangement with no phone problem. Since the most she would be willing to pay to avoid the phone problem is $150 per month, the highest monthly rent she would be willing to pay for the shared apartment is $400 − $150 = $250. If she pays that amount, Ann will have to pay the difference, namely, $350 per month, which is clearly a better alternative for Ann than paying $400 to live alone. EXAMPLE 11.8 Cost-Benefit Principle—Splitting Economic Surplus How much should Ann and Betty pay if they agree to split their economic surplus equally? As we saw in Table 11.3, the total rent saving from the shared apartment is $200, and since the least costly solution to the phone problem is $150, the monthly gain in economic surplus is $50. We know from Example 11.7 that Ann's reservation price for living together is $400 per month and Betty's is $250. So if the two women want to split the $50 monthly surplus equally, each should pay $25 less than her reservation price. Ann's monthly rent will thus be $375 and Betty's, $225. The result is that each is $25 per month better off than if she had lived alone.

CONCEPT CHECK 11.2 As in Examples 11.6 and 11.7, Ann and Betty can live together in a two-bedroom apartment for $600 per month or separately in 2 one-bedroom apartments, each for $400 per month. Ann would pay up to $250 per month rather than moderate her telephone habits, and Betty would pay up to $150 per month to achieve reasonable access to the telephone. Now, suppose Betty would also be willing to pay up to $60 per month to avoid the loss of privacy that comes with shared living space. Should the two women live together?

POSITIONAL ARMS RACES AND POSITIONAL ARMS CONTROL AGREEMENTS The steroid problem is an example of a positional externality. Whenever the payoffs to one contestant depend at least in part on how he or she performs relative to a rival, any step that improves one side's relative position must necessarily worsen the other's. The shouting-at-parties example discussed in the chapter on games and strategic behavior is another instance of a positional externality. Just as the invisible hand of the market is weakened by the presence of standard externalities, it is also weakened by positional externalities. We have seen that positional externalities often lead contestants to engage in an escalating series of mutually offsetting investments in performance enhancement. We call such spending patterns positional arms races. Because positional arms races produce inefficient outcomes, people have an incentive to curtail them. Steps taken to reduce positional arms races, such as blue laws and rules against anabolic steroids, may therefore be thought of as positional arms control agreements. Once you become aware of positional arms races, you will begin to see them almost everywhere. You can hone your skills as an economic naturalist by asking these questions about every competitive situation you observe: What form do the investments in performance enhancement take? What steps have contestants taken to limit these investments? Sometimes positional arms control agreements are achieved by the imposition of formal rules or by the signing of legal contracts. Some examples of this type of agreement follow.

Campaign Spending Limits In the United States, presidential candidates routinely spend hundreds of millions of dollars on advertising. Yet if both candidates double their spending on ads, each one's odds of winning will remain essentially the same. Recognition of this pattern led Congress to adopt strict spending limits for presidential candidates. (That those regulations have proved difficult to enforce does not call into question the logic behind the legislation.) Roster Limits Major League Baseball permits franchises to have only 25 players on the roster during the regular season. The National Football League sets its roster limit at 53; the National Basketball Association at 12. Why these limits? In their absence, any team could increase its chance of winning by simply adding players. Inevitably, other teams would follow suit. On the plausible assumption that, beyond some point, larger rosters do not add much to the entertainment value for fans, roster limits are a sensible way to deliver sports entertainment at a more reasonable cost.

Harvesting Timber on Remote Public Land On remote public lands, enforcing restrictions against cutting down trees may be impractical. Each tree cutter knows that a tree that is not harvested this year will be bigger, and hence more valuable, next year. But he also knows that if he doesn't cut the tree down this year, someone else might do so. In contrast, private companies that grow trees on their own land have no incentive to harvest timber prematurely and a strong incentive to prevent outsiders from doing so. Harvesting Whales in International Waters Each individual whaler knows that harvesting an extra whale reduces the breeding population, and hence the size of the future whale population. But the whaler also knows that any whale that is not harvested today may be taken by some other whaler. The solution would be to define and enforce property rights to whales. But the oceans are vast, and the behavior of whalers is hard to monitor. And even if their behavior could be monitored, the concept of national sovereignty would make the international enforcement of property rights problematic. More generally, the animal species that are most severely threatened with extinction tend to be those that are economically valuable to humans but that are not privately owned by anyone. This is the situation confronting whales as well as elephants. Contrast this with the situation confronting chickens, which are also economically valuable to humans but which, unlike whales, are governed by traditional laws of private property. This difference explains why no one worries that Colonel Sanders might threaten the extinction of chickens.

Controlling Multinational Environmental Pollution Each individual polluter may know that if he and all others pollute, the damage to the environment will be greater than the cost of not polluting. But if the environment is common property into which all are free to dump, each has a powerful incentive to pollute. Enforcing laws and regulations that limit the discharge of pollution may be practical if all polluters live under the jurisdiction of a single government. But if polluters come from many different countries, solutions are much more difficult to implement. Thus, the Mediterranean Sea has long suffered serious pollution since none of the many nations that border it has an economic incentive to consider the effects of its discharges on other countries. As the world's population continues to grow, the absence of an effective system of international property rights will become an economic problem of increasing significance. RECAP PROPERTY RIGHTS AND THE TRAGEDY OF THE COMMONS When a valuable resource has a price of zero, people will continue to exploit it as long as its marginal benefit remains positive. The tragedy of the commons describes situations in which valuable resources are squandered because users are not charged for them. In many cases, an efficient remedy is to define and enforce rights to the use of valuable property. But this solution is difficult to implement for resources such as the oceans and the atmosphere because no single government has the authority to enforce property rights for these resources.

Early estimates by the IPCC suggest that a tax of between $20 and $80 per ton on carbon emissions would be needed by 2030 to achieve climate stability by 2100. The organization also noted, however, that technical advances might reduce the required levy to as little as $5 per ton.4 Under a carbon tax, the prices of goods would rise in proportion to their carbon footprints. A tax of $80 per ton, for example, would raise the price of gasoline by about 70 cents a gallon, while a tax of $5 per ton would raise prices by less than 5 cents a gallon. Even a dramatically higher tax on carbon—say, $300 a ton—would raise the price of gasoline by less than $3 a gallon. As American motorists saw in 2008, a sudden price increase of that magnitude could indeed be painful. But if phased in gradually, it would cause much less harm. Facing steadily increasing fuel prices, for example, manufacturers would scramble to develop more fuel-efficient vehicles. Many Europeans now pay $4 a gallon more for gas than Americans do. But precisely because of that fact, European automakers have pioneered development of many of the world's most fuel-efficient cars. Europeans actually spend less on gas than Americans do, yet seem no less happy with their rides. If a family traded in its aging Ford Explorer (15 mpg) for a Ford Focus wagon (32 mpg), it would spend less on gas than before, even if it drove just as much. The tax could be phased in slowly, to give people time to adjust. People would also move closer to work, form car pools, choose less distant vacation destinations, and so on. Some of the revenue from the tax could be used to send checks to low-income families to ease the burden of higher gas prices. Portions of it could help pay down debt and rebuild crumbling infrastructure, or reduce other taxes. In 2009 the U.S. House of Representatives actually passed an energy bill that included a comprehensive carbon cap and trade system, the functional equivalent of a carbon tax. But the bill couldn't win Senate approval, and seasoned congressional observers now see little chance that meaningful climate legislation could win passage in Congress anytime soon. Some argue that taxing carbon emissions would be a waste of time unless other countries did likewise. It's a fair point. But World Trade Organization officials have indicated that countries could tax imported goods in proportion to their carbon dioxide emissions if exporting countries failed to enact carbon taxes at home. Access to the American market is a potent bargaining chip. Countries that sell in the U.S. would be quick to enact carbon taxes of their own rather than allow the U.S. to reap the revenue from a carbon tax levied on goods imported into the U.S.

Cost-Benefit In short, the economist's cost-benefit framework suggests that our failure to enact carbon taxes constitutes a mystery of the highest order. The explanation, perhaps, is that even the soundest policy proposals can sometimes take decades to win legislative approval. The problem of acid rain is an instructive case in point. Electric power plants in the Midwest had long burned high-sulfur coal, in the process discharging large quantities of sulfur dioxide (SO2) from their smokestacks. Prevailing winds carried these emissions eastward, where they precipitated out over New York State and New England as acid rain, killing large quantities of trees and fish. Beginning in the 1960s, economists advocated addressing this problem by requiring firms to acquire marketable permits for each ton of SO2 they emitted. But as discussed earlier, economists' proposals, despite their compelling logic, languished in Congress for more than three decades. Only with the passage of amendments to the Clean Air Act in 1995 did Congress require the establishment of a market for permits for discharging SO2. As economists had predicted, the permit system worked spectacularly well. Acid rain caused by SO2 emissions quickly plummeted, and at about one-sixth the cost that more complex regulatory approaches would have entailed.5 Once people have to pay for their emissions, they quickly find ingenious ways of reducing them RECAP USING PRICE INCENTIVES IN ENVIRONMENTAL REGULATION An efficient program for reducing pollution is one for which the marginal cost of abatement is the same for all polluters. Taxing pollution has this desirable property, as does the auction of pollution permits. The auction method has the advantage that regulators can achieve a desired abatement target without having detailed knowledge of the abatement technologies available to polluters. Climate scientists warn that increasing atmospheric concentrations of greenhouse gases threatens to cause catastrophic global warming. That risk could be averted by imposition of a carbon tax or equivalent carbon permit system.

CONCEPT CHECK 11.3 How would your answers to Examples 11.9 and 11.10 change if the interest rate were 11 percent per year rather than 13 percent? Why do the villagers in Examples 11.9 and 11.10 do better when they make their investment decisions collectively? The answer is that when individuals decide alone, they ignore the fact that sending another steer onto the commons will cause existing steers to gain less weight. Their failure to consider this effect makes the return from sending another steer seem misleadingly high to them. The grazing land on the commons is a valuable economic resource. When no one owns it, no one has any incentive to take the opportunity cost of using it into account. And when that happens, people will tend to use it until its marginal benefit is zero. This problem, and others similar to it, are known as the tragedy of the commons. The essential cause of the tragedy of the commons is the fact that one person's use of commonly held property imposes an external cost on others by making the property less valuable. The tragedy of the commons also provides a vivid illustration of the Equilibrium Principle. Each individual villager behaves rationally by sending an additional steer onto the commons, yet the overall outcome falls far short of the attainable ideal. Equilibrium THE EFFECT OF PRIVATE OWNERSHIP As the following example illustrates, one solution to the tragedy of the commons is to place the village grazing land under private ownership.

EXAMPLE 11.11 Private Ownership How much will the right to control the village commons sell for? Suppose the five villagers face the same investment opportunities as before, except that this time they decide to auction off the right to use the commons to the highest bidder. Assuming that villagers can borrow as well as lend at an annual interest rate of 13 percent, what price will the right to use the commons fetch? How will the owner of that property right use it, and what will be the resulting village income? To answer these questions, simply ask yourself what you would do if you had complete control over how the grazing land were used. As we saw earlier, the most profitable way to use this land is to send only a single steer to graze on it. If you do so, you will earn a total of $26 per year. Since the opportunity cost of the $100 you spent on the single yearling steer is the $13 in interest you could have earned from a bond, your economic profit from sending a single steer onto the commons will be $13 per year, provided you can use the land for free. But you cannot; to finance your purchase of the property right, you must borrow money (since you used your $100 savings to buy a year-old steer). What is the most you would be willing to pay for the right to use the commons? Its use generates an income of $26 per year—or $13 more than the opportunity cost of your investment in the steer—so the most you would pay is $100 (since that amount used to purchase a bond that pays 13 percent interest would also generate income of $13 per year). If the land were sold at auction, $100 is precisely the amount you would have to pay. Your annual earnings from the land would be exactly enough to pay the $13 interest on your loan and cover the opportunity cost of not having put your savings into a bond. Note that when the right to use the land is auctioned to the highest bidder, the village achieves a more efficient allocation of its resources because the owner has a strong incentive to take the opportunity cost of more intensive grazing fully into account. Total village income in this case will again be $78. If the annual interest on the $100 proceeds from selling the land rights is shared equally among the five villagers, each will again have an annual investment income of $15.60. The logic of economic surplus maximization helps to explain why the most economically successful nations have all been ones with well-developed private property laws. Property that belongs to everyone belongs, in effect, to no one. Not only is its potential economic value never fully realized; it usually ends up being of no value at all. Bear in mind, however, that in most countries the owners of private property are not free to do precisely as they wish with it. For example, local zoning laws may give the owner of a residential building lot the right to build a three-story house but not a taller one. Here, too, the logic of economic surplus maximization applies, for a fully informed and rational legislature would define property rights so as to create the largest possible total economic surplus. In practice, of course, such ideal legislatures never really exist. Yet the essence of politics is the cutting of deals that make people better off. If a legislator could propose a change in the property laws that would enlarge the total economic surplus, she could also propose a scheme that would give each of her constituents a larger slice, thus enhancing her chances for reelection.

CONCEPT CHECK 11.4 In Example 11.12, if the tax were $61 per ton of pollution emitted each day, which production processes would the two firms adopt? The advantage of the tax approach is that it concentrates pollution reduction in the hands of the firms that can accomplish it at least cost. Requiring each firm to cut emissions by the same proportion ignores the fact that some firms can reduce pollution much more cheaply than others. Note that under the tax approach, the cost of the last ton of smoke removed is the same for each firm, so the efficiency condition is satisfied. One problem with the tax approach is that unless the government has detailed knowledge about each firm's cost of reducing pollution, it cannot know how high to set the pollution tax. A tax that is too low will result in too much pollution, while a tax that is too high will result in too little. Of course, the government could start by setting a low tax rate and gradually increase the rate until pollution is reduced to the target level. But because firms often incur substantial sunk costs when they switch from one process to another, that approach might be even more wasteful than requiring all firms to cut their emissions by the same proportion. AUCTIONING POLLUTION PERMITS Another alternative is to establish a target level for pollution and then auction off permits to emit that level. The virtues of this approach are illustrated in the following example.

EXAMPLE 11.13 Pollution Permits How much will pollution permits sell for? Two firms, Sludge Oil and Northwest Lumber, again have access to the production processes described earlier (which are reproduced in Table 11.8). The government's goal is to cut the current level of pollution, 8 tons per day, by half. To do so, the government auctions off four permits, each of which entitles the bearer to emit 1 ton of smoke per day. No smoke may be emitted without a permit. What price will the pollution permits fetch at auction, how many permits will each firm buy, and what will be the total cost of the resulting pollution reduction? If Sludge Oil has no permits, it must use process E, which costs $2,300 per day to operate. If it had one permit, it could use process D, which would save it $1,000 per day. Thus, the most Sludge Oil would be willing to pay for a single 1-ton pollution permit is $1,000 per day. With a second permit, Sludge Oil could switch to process C and save another $700 per day; with a third permit, it could switch to process B and save another $400; and with a fourth permit, it could switch to process A and save another $100. Using similar reasoning, we can see that Northwest Lumber would pay up to $220 for one permit, up to $100 for a second, up to $60 for a third, and up to $20 for a fourth. Suppose the government starts the auction at a price of $90. Sludge Oil will then demand four permits and Northwest Lumber will demand two, for a total demand of six permits. Since the government wishes to sell only four permits, it will keep raising the price until the two firms together demand a total of only four permits. Once the price reaches $101, Sludge Oil will demand three permits and Northwest Lumber will demand only one, for a total quantity demanded of four permits. Compared to the unregulated alternative, in which each firm used process A, the daily cost of the auction solution is $280: Sludge Oil spends $100 switching from process A to process B, and Northwest Lumber spends $180 switching from A to D. This total is $300 less than the cost of requiring each firm to reduce its emissions by half. (Again, the permit fees paid by the firms do not constitute a cost of cleanup because the money can be used to reduce taxes that would otherwise have to be collected.)

THE COASE THEOREM Equilibrium --> To say that a situation is inefficient means that it can be rearranged in a way that would make at least some people better off without harming others. Such situations, we have seen, are a source of creative tension. The existence of inefficiency, after all, means that there is cash on the table, which usually triggers a race to see who can capture it. For example, we saw that because monopoly pricing results in an inefficiently low output level, the potential for gain gave monopolists an incentive to make discounts available to price-sensitive buyers. As the next examples illustrate, the inefficiencies that result from externalities create similar incentives for remedial action.

EXAMPLE 11.3 Inefficiencies That Result from Externalities Will Abercrombie dump toxins in the river? (Part I) Abercrombie's factory produces a toxic waste by-product. If Abercrombie dumps it in the river, he causes damage to Fitch, a fisherman located downstream. The toxins are short-lived and cause no damage to anyone other than Fitch. At a cost, Abercrombie can filter out the toxins, in which case Fitch will suffer no damage at all. The relevant gains and losses for the two individuals are listed in Table 11.1. If the law does not penalize Abercrombie for dumping toxins in the river, and if Abercrombie and Fitch cannot communicate with one another, will Abercrombie operate with or without a filter? Is that choice socially efficient? Abercrombie has an incentive to operate without a filter since he earns $30 per day more than if he operates with a filter. But the outcome when he does so is socially inefficient. Thus, when Abercrombie operates without a filter, the total daily gain to both parties is only $130 + $50 = $180, compared to $100 + $100 = $200 if Abercrombie had operated with a filter. The daily cost of the filter to Abercrombie is only $130 − $100 = $30, which is smaller than its daily benefit to Fitch of $100 − $50 = $50. The fact that Abercrombie does not install the filter implies a squandered daily surplus of $20.

EXAMPLE 11.5 Social Efficiency Will Abercrombie dump toxins in the river? (Part 3) Suppose the law says that Abercrombie may not dump toxins in the river unless he has Fitch's permission. If the relevant costs and benefits of filtering the toxins are as shown in Table 11.2, and if Abercrombie and Fitch can negotiate with one another at no cost, will Abercrombie filter out the toxins? Note that this time, the most efficient outcome is for Abercrombie to operate without a filter because the total daily surplus in that case will be $220 as compared to only $200 with a filter. Under the law, however, Fitch has the right to insist that Abercrombie use a filter. We might expect him to exercise that right since his own gain would rise from $70 to $100 per day if he did so. But because this outcome would be socially inefficient, we know that each party can do better. Suppose, for example, that Abercrombie gives Fitch $40 per day in return for Fitch's permission to operate without a filter. Each would then have a net daily gain of $110, which is $10 better for each of them than if Fitch had insisted that Abercrombie use a filter. Abercrombie's pollution harms Fitch, sure enough. But failure to allow the pollution would have caused even greater harm to Abercrombie. The Coase theorem tells us that regardless of whether the law holds polluters liable for damages, the affected parties will achieve efficient solutions to externalities if they can negotiate costlessly with one another. Note carefully that this does not imply that affected parties will be indifferent about whether the law holds polluters responsible for damages. If polluters are liable, they will end up with lower incomes and those who are injured by pollutants will end up with higher incomes than if the law does not hold polluters liable—even though the same efficient production methods would be adopted in each case. When polluters are held liable, they must remove the pollution at their own expense. When they are not held liable, those who are injured by pollution must pay polluters to cut back. Externalities are hardly rare and isolated occurrences. On the contrary, finding examples of actions that are altogether free of them is difficult. And because externalities can distort the allocation of resources, it is important to recognize them and deal intelligently with them. Consider the following example of an externality that arises because of shared living arrangements.

EXAMPLE 11.6 Cost-Benefit Principle—Shared Living Expenses Will Ann and Betty share an apartment? Ann and Betty can live together in a two-bedroom apartment for $600 per month, or separately in 2 one-bedroom apartments, each for $400 per month. If the rent paid were the same for both alternatives, the two women would be indifferent between living together or separately, except for one problem: Ann talks constantly on the telephone. Ann would pay up to $250 per month for this privilege. Betty, for her part, would pay up to $150 per month to have better access to the phone. If the two cannot install a second phone line, should they live together or separately? Ann and Betty should live together only if the benefit of doing so exceeds the cost. The benefit of living together is the reduction in their rent. Since 2 one-bedroom apartments would cost a total of $800 per month, compared to $600 for a two-bedroom unit, their benefit from living together is $200 per month. Their cost of living together is the least costly accommodation they can make to Ann's objectionable telephone habits. Ann would be willing to pay up to $250 per month to avoid changing her behavior, so the $200 rent saving is too small to persuade her to change. But Betty is willing to put up with Ann's behavior for a compensation payment of only $150 per month. Since that amount is smaller than the total saving in rent, the least costly solution to the problem is for Betty to live with Ann and simply put up with her behavior. Table 11.3 summarizes the relevant costs and benefits of this shared living arrangement. Cost-Benefit The Cost-Benefit Principle tells us that Ann and Betty should live together if and only if the benefit of living together exceeds the cost. The cost of the shared living arrangement is not the sum of all possible costs but the least costly accommodation to the problem (or problems) of shared living. Since the $200 per month saving in rent exceeds the least costly accommodation to the phone problem, Ann and Betty can reap a total gain in economic surplus of $50 per month by sharing their living quarters. Some people might conclude that Ann and Betty should not live together because if the two share the rent equally, Betty would end up paying $300 per month—which when added to the $150 cost of putting up with Ann's phone behavior comes to $50 more than the cost of living alone. As persuasive as that argument may sound, however, it is mistaken. The source of the error, as the following example illustrates, is the assumption that the two must share the rent equally.

EXAMPLE 11.2 Negative Externalities Does the honeybee keeper face the right incentives? (Part 2) As in Example 11.1, Phoebe earns her living as a keeper of honeybees. But now her neighbors are not apple growers but an elementary school and a nursing home. The more hives Phoebe keeps, the more students and nursing home residents will be stung by bees. If Phoebe takes only her own costs and benefits into account in deciding how many hives to keep, will she keep the socially optimal number of hives? For the students and nursing home residents, Phoebe's hives constitute an external cost, or a negative externality. If she considers only her own costs and benefits in deciding how many hives to keep, she will continue to add hives until the added revenue from the last hive is just enough to cover its cost. But since Phoebe's neighbors also incur costs when she adds a hive, the benefit of the last hive at that point will be smaller than its cost. Phoebe, in other words, will keep too many hives. Every activity involves costs and benefits. When all the relevant costs and benefits of an activity accrue directly to the person who carries it out—that is, when the activity generates no externalities—the level of the activity that is best for the individual will be best for society as a whole. But when an activity generates externalities, be they positive or negative, individual self-interest does not produce the best allocation of resources. Individuals who consider only their own costs and benefits will tend to engage too much in activities that generate negative externalities and too little in activities that generate positive externalities. When an activity generates both positive and negative externalities, private and social interests will coincide only in the unlikely event that the opposing effects offset one another exactly.

HOW DO EXTERNALITIES AFFECT SUPPLY AND DEMAND? The effects of externalities on resource allocation can be shown in a supply and demand diagram. Consider first the case of negative externalities. Figure 11.1(a) depicts the supply (Private MC) and demand curves for a product whose production involves no external costs or benefits. Imagine, say, that the energy that powers the factories in this market comes from nonpolluting hydroelectric generators. The resulting equilibrium price and quantity in the market for this product will then be socially optimal: the value to buyers of the last unit of the product consumed (as measured on the demand curve) will be exactly equal to the marginal cost of producing it (as measured on the supply curve), leaving no further possible gains from exchange (see Chapter 3, Supply and Demand, and Chapter 7, Efficiency, Exchange, and the Invisible Hand in Action). (FIGURE 11.1 How External Costs Affect Resource Allocation. (a) When a market has no external costs or benefits, the resulting equilibrium quantity and price are socially optimal. (b) By contrast, when production of a good is accompanied by an external cost, the market equilibrium price ($1,300 per ton) is too low and the market equilibrium quantity (12,000 tons per year) is too high. The deadweight loss from the negative externality is the area of the blue-shaded triangle, $2 million per year.) But now suppose that a protracted drought has eliminated hydroelectric power generation, forcing factories to rely instead on electric power produced by coal-burning generators. Now each unit of output produced is accompanied by an external pollution cost of XC, as shown in Figure 11.1(b). Since the external pollution cost falls not on firm owners but on others who live downwind from their factories, Private MC is still the supply curve for this product, and its demand curve is again as before, so the equilibrium price and quantity will be exactly the same as in Figure 11.1(a). But this time the private market equilibrium is not socially optimal. As before, the market equilibrium level of output is 12,000 tons per year, the output level at which the demand curve (D) intersects Private MC. Note, however, that at that output level, the value to consumers of the last unit of output produced is only $1,300 per ton, while the true cost of producing that last unit (including the external cost) is $2,300 per ton.

EXTERNAL COSTS AND BENEFITS External costs and external benefits—externalities, for short—are activities that generate costs or benefits that accrue to people not directly involved in those activities. These effects are generally unintended. From the pipe smoker's point of view, the noise generated by the marauding boys was an external cost. Had others been disturbed by the boys' rowdiness, they may well have regarded the pipe smoker's retaliatory gesture as an external benefit. This chapter focuses on how externalities affect the allocation of resources. Adam Smith's theory of the invisible hand applies to an ideal marketplace in which externalities do not exist. In such situations, Smith argued, the self-interested actions of individuals would lead to socially efficient outcomes. We will see that when the parties affected by externalities can easily negotiate with one another, the invisible hand will still produce an efficient outcome. But in many cases, such as the scene depicted in the tobacco ad, negotiation is impractical. In those cases, the self-serving actions of individuals won't lead to efficient outcomes. The need to deal with externalities and other collective-action problems is one of the most important rationales for the existence of government along with a variety of other forms of collective action.

HOW EXTERNALITIES AFFECT RESOURCE ALLOCATION The following examples illustrate the ways in which externalities distort the allocation of resources. EXAMPLE 11.1 Positive Externalities Does the honeybee keeper face the right incentives? (Part I) Phoebe earns her living as a keeper of honeybees. Her neighbors on all sides grow apples. Because bees pollinate apple trees as they forage for nectar, the more hives Phoebe keeps, the larger the harvests will be in the surrounding orchards. If Phoebe takes only her own costs and benefits into account in deciding how many hives to keep, will she keep the socially optimal number of hives? Phoebe's hives constitute an external benefit, or a positive externality, for the orchard owners. If she takes only her own personal costs and benefits into account, she will add hives only until the added revenue she gets from the last hive just equals the cost of adding it. But because the orchard owners also benefit from additional hives, the total benefit of adding another hive at that point will be greater than its cost. Phoebe, then, will keep too few hives. As we will discuss later in the chapter, problems like the one in Example 11.1 have several possible solutions. One is for orchard owners to pay beekeepers for keeping additional hives. But such solutions often require complex negotiations between the affected parties. For the moment, we assume that such negotiations are not practical.

EXAMPLE 11.9 Individual Income How many steers will villagers send onto the commons? A village has five residents, each of whom has accumulated savings of $100. Each villager can use the money to buy a government bond that pays 13 percent interest per year or to buy a year-old steer, send it onto the commons to graze, and sell it after 1 year. The price the villager will get for the 2-year-old steer depends on the amount of weight it gains while grazing on the commons, which in turn depends on the number of steers sent onto the commons, as shown in Table 11.4. The price of a 2-year-old steer declines with the number of steers grazing on the commons because the more steers, the less grass available to each. The villagers make their investment decisions one at a time, and the results are public. If each villager decides how to invest individually, how many steers will be sent onto the commons, and what will be the village's total income? If a villager buys a $100 government bond, he'll earn $13 of interest income at the end of 1 year. Thus, he should send a steer onto the commons if and only if that steer will command a price of at least $113 as a 2-year-old. When each villager chooses in this self-interested way, we can expect four villagers to send a steer onto the commons. (Actually, the fourth villager would be indifferent between investing in a steer or buying a bond since he would earn $13 either way. For the sake of discussion, we'll assume that in the case of a tie, people choose to be cattle owners.) The fifth villager, seeing that he would earn only $11 by sending a fifth steer onto the commons, will choose instead to buy a government bond. As a result of these decisions, the total village income will be $65 per year—$13 for the one bondholder and 4($13) = $52 for the four cattle owners.

Has Adam Smith's invisible hand produced the most efficient allocation of these villagers' resources? We can tell at a glance that it has not, since their total village income is only $65—precisely the same as it would have been had the possibility of cattle raising not existed. The source of the difficulty will become evident in the following example. EXAMPLE 11.10 Maximizing Total Group Income What is the socially optimal number of steers to send onto the commons? Suppose the five villagers in the previous example confront the same investment opportunities as before, except that this time they are free to make their decisions as a group rather than individually. How many steers will they send onto the commons, and what will be their total village income? This time the villagers' goal is to maximize the income received by the group as a whole. When decisions are made from this perspective, the criterion is to send a steer onto the commons only if its marginal contribution to village income is at least $13, the amount that could be earned from a government bond. As the entries in the last column of Table 11.5 indicate, the first steer clearly meets this criterion since it contributes $26 to total village income. But the second steer does not. Sending that steer onto the commons raises the village's income from cattle raising from $26 to $38, a gain of just $12. The $100 required to buy the second steer would thus have been better invested in a government bond. Worse, the collective return from sending a third steer is only $10; from a fourth, only $4; and from a fifth, only $3. In sum, when investment decisions are made with the goal of maximizing total village income, the best choice is to buy four government bonds and send only a single steer onto the commons. The resulting village income will be $78: $26 from sending the single steer and $52 from the four government bonds. That amount is $13 more than the total income that resulted when villagers made their investment decisions individually. Once again, the reward from moving from an inefficient allocation to an efficient one is that the economic pie grows larger. And when the pie grows larger, everyone can get a larger slice. For instance, if the villagers agree to pool their income and share it equally, each will get $15.60, or $2.60 more than before.

Arbitration Agreements In the business world, contracting parties often sign a binding agreement that commits them to arbitration in the event of a dispute. By doing so, they sacrifice the option of pursuing their interests as fully as they might wish to later, but they also insulate themselves from costly legal battles. Other parties in the legal system may sometimes take steps to limit spending on litigation. For example, a federal judge in South Dakota announced—presumably to the approval of litigants—that he would read only the first 15 pages of any brief submitted to his court.

Mandatory Starting Dates for Kindergarten A child who is a year or so older than most of her kindergarten classmates is likely to perform better, in relative terms, than if she had entered school with children her own age. And since most parents are aware that admission to prestigious universities and eligibility for top jobs upon graduation depend largely on relative academic performance, many are tempted to keep their children out of kindergarten a year longer than necessary. Yet there is no social advantage in holding all children back an extra year since their relative performance would essentially be unaffected. In most jurisdictions, therefore, the law requires children who reach their fifth birthday before December 1 of a given year to start kindergarten the same year.

SOCIAL NORMS AS POSITIONAL ARMS CONTROL AGREEMENTS In some cases, social norms may take the place of formal agreements to curtail positional arms races. Some familiar examples follow. Nerd Norms Some students care more—in the short run, at least—about the grades they get than how much they actually learn. When such students are graded on the curve—that is, on the basis of their performance relative to other students—a positional arms race ensues because if all students were to double the amount of time they studied, the distribution of grades would remain essentially the same. Students who find themselves in this situation are often quick to embrace "nerd norms," which brand as social misfits those who "study too hard." Fashion Norms Social norms regarding dress and fashion often change quickly because of positional competition. Consider, for instance, the person who wishes to be on the cutting edge of fashion. In some American social circles during the 1950s, that goal could be accomplished by having pierced ears. But as more and more people adopted the practice, it ceased to communicate avant-garde status. At the same time, those who wanted to make a conservative fashion statement gradually became freer to have their ears pierced. For a period during the 1960s and 1970s, one could be on fashion's cutting edge by wearing two earrings in one earlobe. But by the 1990s multiple ear piercings had lost much of their social significance, the threshold of cutting-edge status having been raised to upward of a dozen piercings of each ear or a smaller number of piercings of the nose, eyebrows, or other body parts. A similar escalation has taken place in the number, size, and placement of tattoos. The increase in the required number of tattoos or body piercings has not changed the value of avant-garde fashion status to those who desire it. Being on the outer limits of fashion has much the same meaning now as it once did. To the extent that there are costs associated with body piercings, tattoos, and other steps required to achieve avant-garde status, the current fashions are wasteful compared to earlier ones. In this sense, the erosion of social norms against tattoos and body piercings has produced a social loss. Of course, the costs associated with this loss are small in most cases. Yet since each body piercing entails a small risk of infection, the costs will continue to rise with the number of piercings. And once those costs reach a certain threshold, support may mobilize on behalf of social norms that discourage these activities.

Norms of Taste Similar cycles occur with respect to behaviors considered to be in bad taste. In the 1950s, for example, prevailing norms prevented major national magazines from accepting ads that featured nude photographs. Naturally, advertisers had a powerful incentive to chip away at such norms in an effort to capture the reader's limited attention. And indeed, taboos against nude photographs have eroded in the same way as with those against body piercings and tattoos. Consider, for instance, the evolution of perfume ads. First came the nude silhouette; then, increasingly well-lit and detailed nude photographs; and more recently, photographs of what appear to be group sex acts. Each innovation achieved just the desired effect: capturing the reader's instant and rapt attention. Inevitably, however, other advertisers followed suit, causing a shift in our sense of what is considered attention-grabbing. Photographs that once would have shocked readers now often draw little more than a bored glance. Opinions differ, of course, about whether this change is an improvement. Many believe that the earlier, stricter norms were ill-advised, the legacy of a more prudish and repressive era. Yet even people who take that view are likely to believe that some kinds of photographic material ought not to be used in magazine advertisements. Obviously, what is acceptable will differ from person to person, and each person's threshold of discomfort will depend in part on current standards. But as advertisers continue to break new ground in their struggle to capture attention, the point may come when people begin to mobilize in favor of stricter standards of "public decency." Such a campaign would provide yet another case of a positional arms control agreement. Norms against Vanity Cosmetic and reconstructive surgery has produced dramatic benefits for many people, enabling badly disfigured accident victims to recover a normal appearance. It also has eliminated the extreme self-consciousness felt by people born with strikingly unusual features. Such surgery, however, is by no means confined to the conspicuously disfigured. Increasingly, "normal" people are seeking surgical improvements to their appearance. Some 23 million cosmetic "procedures" were done in 2016 and demand has continued to grow. Once a carefully guarded secret, these procedures are now offered as prizes in southern California charity raffles. In individual cases, cosmetic surgery may be just as beneficial as reconstructive surgery is for accident victims. Buoyed by the confidence of having a straight nose or a wrinkle-free complexion, patients sometimes go on to achieve much more than they ever thought possible. But the growing use of cosmetic surgery also has had an unintended side effect: It has altered the standards of normal appearance. A nose that once would have seemed only slightly larger than average may now seem jarringly big. The same person who once would have looked like an average 55-year-old may now look nearly 70. And someone who once would have tolerated slightly thinning hair or an average amount of cellulite may now feel compelled to undergo hair transplantation or liposuction. Because such procedures shift people's frame of reference, their payoffs to individuals are misleadingly large. From a social perspective, therefore, reliance on them is likely to be excessive. Legal sanctions against cosmetic surgery are difficult to imagine. But some communities have embraced powerful social norms against cosmetic surgery, heaping scorn and ridicule on the consumers of face-lifts and tummy tucks. In individual cases, such norms may seem cruel. Yet without them, many more people might feel compelled to bear the risk and expense of cosmetic surgery.

Why does the government subsidize private property owners to plant trees on their hillsides? Societies use laws not only to discourage activities that generate negative externalities, but also to encourage activities that generate positive externalities. The planting of trees on hillsides, for example, benefits not just the landowner, but also his neighbors by limiting the danger of flooding. In recognition of this fact, many jurisdictions subsidize the planting of trees. Similarly, Congress budgets millions of dollars each year in support of basic research—an implicit acknowledgment of the positive externalities associated with the generation of new knowledge. Why does the government subsidize scientific research? RECAP EXTERNAL COSTS AND BENEFITS Externalities occur when the costs or benefits of an activity accrue to people other than those directly involved in the activity. The Coase theorem says that when affected parties can negotiate with one another without cost, activities will be pursued at efficient levels, even in the presence of positive or negative externalities. But when negotiation is prohibitively costly, inefficient behavior generally results. Activities that generate negative externalities are pursued to excess, while those that generate positive externalities are pursued too little. Laws and regulations, including taxes and subsidies, are often adopted in an effort to alter inefficient behavior that results from externalities.

PROPERTY RIGHTS AND THE TRAGEDY OF THE COMMONS People who grow up in industrialized nations tend to take the institution of private property for granted. Our intuitive sense is that people have the right to own any property they acquire by lawful means and to do with that property as they see fit. In reality, however, property laws are considerably more complex in terms of the rights they confer and the obligations they impose. THE PROBLEM OF UNPRICED RESOURCES To understand the laws that govern the use of property, let's begin by asking why societies created the institution of private property in the first place. The following examples, which show what happens to property that nobody owns, suggest an answer.

The Economic Naturalist 11.1 What is the purpose of free speech laws? The First Amendment's protection of free speech and the pattern of exceptions to that protection are another illustration of how legal remedies are used to solve the problems caused by externalities. The First Amendment acknowledges the decisive value of open communication, as well as the practical difficulty of identifying and regulating acts of speech that cause more harm than good. Yet there are some important exceptions. The Supreme Court has ruled, for instance, that the First Amendment does not allow someone to yell "fire" in a crowded theater if there is no fire, nor does it allow someone to advocate the violent overthrow of the government. In those instances, the external benefits of free speech are far too small to justify the external costs. Why does the U.S. Constitution protect the right of free speech? The Economic Naturalist 11.2 Why do many states have laws requiring students to be vaccinated against childhood illnesses? Proof of immunization against diphtheria, measles, poliomyelitis, and rubella is now universally required for entry into American public schools. Most states also require immunization against tetanus (50 states), pertussis (50 states), mumps (49 states), and hepatitis B (45 states). Why these requirements? Vaccinating children against childhood illnesses can entail a small but potentially serious risk. On the other hand, it can protect children against dangerous diseases. For an individual family, the decision to vaccinate involves weighing the benefits of vaccination against its potential risks and cost. The problem is that this calculation ignores the fact that a family's decision to become vaccinated benefits not just the family, but also everyone else in the community because the family would be far less likely to contract the illness and pass it on to others.

Relegating the vaccination decision to individuals would result in a suboptimally low vaccination rate because many families would fail to take adequate account of the benefit that becoming vaccinated would have on others. It is for this reason that most states require vaccinations against specific childhood illnesses. Even these laws, however, allow parents to apply for exemptions on religious or philosophical grounds. Communities vary in the extent to which parents avail themselves of these exemptions. In Colorado, for example, Boulder County heads the list of parents who opt to exempt their children from taking the pertussis vaccine, where only 84.1 percent of public school children have an up-to-date pertussis vaccination compared to 89.9 percent statewide. Not surprisingly, the incidence of whooping cough is much higher in Boulder (37.4 cases per year per 100,000 people) than in the state as a whole (22.4 cases per year per 100,000 people).1

REMEDIES FOR EXTERNALITIES LAWS AND REGULATIONS We have seen that efficient solutions to externalities can be found whenever the affected parties can negotiate with one another at no cost. But negotiation is not always practical. A motorist with a noisy muffler imposes costs on others, yet they cannot flag him down and offer him a compensation payment to fix his muffler. In recognition of this difficulty, most governments simply require that cars have working mufflers. Indeed, the explicit or implicit purpose of a large share—perhaps the lion's share—of laws is to solve problems caused by externalities. The goal of such laws is to help people achieve the solutions they might have reached had they been able to negotiate with one another. When negotiation is costless, the task of adjustment generally falls on the party who can accomplish it at the lowest cost. For instance, in our examples, Betty put up with Ann's annoying phone habits because doing so was less costly than asking Ann to change her habits. Many municipal noise ordinances also place the burden of adjustment on those who can accomplish it at the lowest cost. Consider, for example, the restrictions on loud party music, which often take effect at a later hour on weekends than on weekdays. This pattern reflects both the fact that the gains from loud music tend to be larger on weekends and the fact that such music is more likely to disturb people on weekdays. By setting the noise curfew at different hours on different days of the week, the law places the burden on partygoers during the week and on sleepers during the weekend. Similar logic explains why noise ordinances allow motorists to honk their horns in most neighborhoods, but not in the immediate vicinity of a hospital. The list of laws and regulations that may be fruitfully viewed as solutions to externalities is a long one. When a motorist drives his car at high speed, he endangers not just his own life and property, but also the lives and property of others. Speed limits, no-passing zones, right-of-way rules, and a host of other traffic laws may be seen as reasoned attempts to limit the harm one party inflicts on another. Many jurisdictions even have laws requiring that motorists install snow tires on their cars by the first of November. These laws promote not just safety, but also the smooth flow of traffic: If one motorist can't get up a snow-covered hill, he delays not only himself, but also the motorists behind him.

Similar reasoning helps us understand the logic of zoning laws that restrict the kinds of activities that take place in various parts of cities. Because many residents place a high value on living in an uncongested neighborhood, some cities have enacted zoning laws specifying minimum lot sizes. In places like Manhattan, where a shortage of land encourages developers to build very large and tall buildings, zoning laws limit both a building's height and the proportion of a lot it may occupy. Such restrictions recognize that the taller a building is, and the greater the proportion of its lot that it occupies, the more it blocks sunlight from reaching surrounding properties. The desire to control external costs also helps to explain why many cities establish separate zones for business and residential activity. Even within business districts, many cities limit certain kinds of commercial activity. For example, in an effort to revitalize the Times Square neighborhood, New York City enacted a zoning law banning adult bookstores and pornographic movie theaters from the area. Limitations on the discharge of pollutants into the environment are perhaps the clearest examples of laws aimed at solving problems caused by externalities. The details of these laws reflect the principle of placing the burden of adjustment on those who can accomplish it at least cost. The discharge of toxic wastes into rivers, for example, tends to be most strictly regulated on those waterways whose commercial fishing or recreational uses are most highly valued. On other waterways, the burden of adjustment is likely to fall more heavily on fishermen, recreational boaters, and swimmers. Similarly, air-quality regulations tend to be strictest in the most heavily populated regions of the country, where the marginal benefit of pollution reduction is the greatest. The following examples suggest additional ways in which Coase's insights about how societies deal with externalities provide rich fodder for the economic naturalist.

As an economic naturalist, challenge yourself to use this framework when thinking about the various restrictions you encounter in private property laws: zoning laws that constrain what you can build and what types of activities you can conduct on your land; traffic laws that constrain what you can do with your car; employment and environmental laws that constrain how you can operate your business. Your understanding of these and countless other laws will be enhanced by the insight that everyone can gain when the private property laws are defined so as to create the largest total economic surplus. WHEN PRIVATE OWNERSHIP IS IMPRACTICAL Don't be misled into thinking that the law provides an ideal resolution of all problems associated with externalities and the tragedy of the commons. Defining and enforcing efficient property rights entail costs, after all, and sometimes, as in the following examples, the costs outweigh the gains.

The Economic Naturalist 11.4 Why do blackberries in public parks get picked too soon? Wild blackberries grow profusely at the edge of a wooded area in a crowded city park. The blackberries will taste best if left to ripen fully, but they still taste reasonably good if picked and eaten a few days early. Will the blackberries be left to ripen fully? Why does fruit that grows in public places get picked too soon? Obviously, the costs of defining and enforcing the property rights to blackberries growing in a public park are larger than the potential gains, so the blackberries will remain common property. That means that whoever picks them first gets them. Even though everyone would benefit if people waited until the berries were fully ripe, everyone knows that those who wait are likely to end up with no berries at all. And that means that the berries will be eaten too soon. The Economic Naturalist 11.5 Why are shared milkshakes consumed too quickly? Sara and Susan are identical twins who have been given a chocolate milkshake to share. If each has a straw and each knows that the other is self-interested, will the twins consume the milkshake at an optimal rate? Why are shared milkshakes drunk too quickly? Because drinking a milkshake too quickly chills the taste buds, the twins will enjoy their shake more if they drink it slowly. Yet each knows that the other will drink any part of the milkshake she doesn't finish herself. The result is that each will consume the shake at a faster rate than she would if she had half a shake all to herself. Here are some further examples in which the tragedy of the commons is not easily solved by defining private ownership rights.

POSITIONAL EXTERNALITIES Former tennis champion Steffi Graf received more than $1.6 million in tournament winnings in 1992; her endorsement and exhibition earnings totaled several times that amount. By any reasonable measure, the quality of her play was outstanding, yet she consistently lost to archrival Monica Seles. But in April 1993, Seles was stabbed in the back by a deranged fan and forced to withdraw from the tour. In the ensuing months, Graf's tournament winnings accumulated at almost double her 1992 pace, despite little change in the quality of her play. PAYOFFS THAT DEPEND ON RELATIVE PERFORMANCE In professional tennis and a host of other competitive situations, the rewards people receive typically depend not only on how they perform in absolute terms but also on how they perform relative to their closest rivals. In these situations, competitors have an incentive to take actions that will increase their odds of winning. For example, tennis players can increase their chances of winning by hiring personal fitness trainers and sports psychologists to travel with them on the tour. Yet the simple mathematics of competition tells us that the sum of all individual payoffs from such investments will be larger than the collective payoff. In any tennis match, for example, each contestant will get a sizable payoff from money spent on fitness trainers and sports psychologists, yet each match will have exactly one winner and one loser, no matter how much players spend. The overall gain to tennis spectators is likely to be small, and the overall gain to players as a group must be zero. To the extent that each contestant's payoff depends on his or her relative performance, then, the incentive to undertake such investments will be excessive, from a collective point of view. Consider the following example.

The Economic Naturalist 11.6 Why do football players take anabolic steroids? The offensive linemen of many National Football League teams currently average more than 330 pounds. In the 1970s, by contrast, offensive linemen in the league averaged barely 280 pounds, and the all-decade linemen of the 1940s averaged only 229 pounds. One reason that today's players are so much heavier is that players' salaries have escalated sharply over the last several decades, which has intensified competition for the positions. Size and strength are the two cardinal virtues of an offensive lineman, and other things being equal, the job will go to the larger and stronger of two rivals. Size and strength, in turn, can be enhanced by the consumption of anabolic steroids. But if all players consume these substances, the rank ordering of players by size and strength—and hence the question of who lands the jobs—will be largely unaffected. And because the consumption of anabolic steroids entails potentially serious long-term health consequences, football players as a group are clearly worse off if they consume these drugs. So why do football players take steroids? Why do so many football players take steroids? The problem here is that contestants for starting berths on the offensive line confront a prisoner's dilemma, like the ones analyzed in Chapter 9, Games and Strategic Behavior. Consider two closely matched rivals—Smith and Jones—who are competing for a single position. If neither takes steroids, each has a 50 percent chance of winning the job and a starting salary of $1 million per year. If both take steroids, each again has a 50 percent chance of winning the job. But if one takes steroids and the other doesn't, the first is sure to win the job. The loser ends up selling insurance for $60,000 per year. Neither likes the fact that the drugs may have adverse health consequences, but each would be willing to take that risk in return for a shot at the big salary. Given these choices, the two competitors face a payoff matrix like the one shown in Table 11.6. Clearly, the dominant strategy for both Smith and Jones is to take steroids. Yet when they do, each gets only the third-best outcome, whereas they could have gotten the second-best outcome by not taking the drugs—hence the attraction of rules that forbid the consumption of anabolic steroids.

Externalities are the costs and benefits of activities that accrue to people who are not directly involved in those activities. When all parties affected by externalities can negotiate with one another at no cost, the invisible hand of the market will produce an efficient allocation of resources. (LO1) According to the Coase theorem, the allocation of resources is efficient in such cases because the parties affected by externalities can compensate others for taking remedial action. (LO2) Negotiation over externalities is often impractical, however. In these cases, the self-serving actions of individuals typically will not lead to an efficient outcome. The attempt to forge solutions to the problems caused by externalities is one of the most important rationales for collective action. Sometimes collective action takes the form of laws and government regulations that alter the incentives facing those who generate, or are affected by, externalities. Such remedies work best when they place the burden of accommodation on the parties who can accomplish it at the lowest cost. Traffic laws, zoning laws, environmental protection laws, and free speech laws are examples. (LO3) Curbing pollution and other negative externalities entails costs as well as benefits. The optimal amount of pollution reduction is the amount for which the marginal benefit of further reduction just equals the marginal cost. In general, this formula implies that the socially optimal level of pollution, or of any other negative externality, is greater than zero. (LO3) When grazing land and other valuable resources are owned in common, no one has an incentive to take into account the opportunity cost of using those resources. This problem is known as the tragedy of the commons. Defining and enforcing private rights governing the use of valuable resources is often an effective solution to the tragedy of the commons. Not surprisingly, most economically successful nations have well-developed institutions of private property. Property that belongs to everyone belongs, in effect, to no one. Not only is its potential economic value never fully realized; it usually ends up having no value at all. (LO4)

The difficulty of enforcing property rights in certain situations explains a variety of inefficient outcomes such as the excessive harvest of whales in international waters and the premature harvest of timber on remote public lands. The excessive pollution of seas that are bordered by many countries also results from a lack of enforceable property rights. (LO4) Situations in which people's rewards depend on how well they perform in relation to their rivals give rise to positional externalities. In these situations, any step that improves one side's relative position necessarily worsens the other's. Positional externalities tend to spawn positional arms races—escalating patterns of mutually offsetting investments in performance enhancement. Collective measures to curb positional arms races are known as positional arms control agreements. These collective actions may take the form of formal regulations or rules such as rules against anabolic steroids in sports, campaign spending limits, and binding arbitration agreements. Informal social norms can also curtail positional arms races. (LO5) An understanding of the forces that give rise to environmental pollution can help to identify those policy measures that will achieve a desired reduction in pollution at the lowest possible cost. Both the taxing of pollution and the sale of transferable permits promote this goal. Each distributes the cost of the environmental cleanup effort so that the marginal cost of pollution abatement is the same for all polluters. (LO6)

TAXING POLLUTION Fortunately, alternative policies can distribute the cleanup more efficiently, even if the government lacks detailed information about how much it costs different firms to curtail pollution. One method is to tax pollution and allow firms to decide for themselves how much pollution to emit. The following example illustrates the logic of this approach. EXAMPLE 11.12 Taxing Pollution What is the least costly way to cut pollution by half? Two firms, Sludge Oil and Northwest Lumber, each have access to five production processes, each of which has a different cost and produces a different amount of pollution. The daily costs of the processes and the number of tons of smoke emitted are as shown in Table 11.7. Pollution is currently unregulated, and negotiation between the firms and those who are harmed by pollution is impossible, which means that each firm uses process A, the least costly of the five. Each firm emits 4 tons of pollution per day, for a total of 8 tons of pollution per day.

The government is considering two options for reducing total emissions by half. One is to require each firm to curtail its emissions by half. The other is to set a tax of $T per ton of smoke emitted each day. How large must T be to curtail emissions by half? What would be the total cost to society under each alternative? If each firm is required to cut pollution by half, each must switch from process A to process C. The result will be 2 tons per day of pollution for each firm. The cost of the switch for Sludge Oil will be $600 per day − $100 per day = $500 per day. The cost to Northwest Lumber will be $380 per day − $300 per day = $80 per day, for a total cost of $580 per day. Consider now how each firm would react to a tax of $T per ton of pollution. If a firm can cut pollution by 1 ton per day, it will save $T per day in tax payments. Whenever the cost of cutting a ton of pollution is less than $T, then each firm has an incentive to switch to a cleaner process. For example, if the tax were set at $40 per ton, Sludge Oil would stick with process A because switching to process B would cost $100 per day extra but would save only $40 per day in taxes. Northwest Lumber, however, would switch to process B because the $40 saving in taxes would be more than enough to cover the $20 cost of switching. The problem is that a $40 per day tax on each ton of pollution results in a reduction of only 1 ton per day, 3 short of the 4-ton target. Suppose instead that the government imposed a tax of $101 per ton. Sludge Oil would then adopt process B because the $100 extra daily cost of doing so would be less than the $101 saved in taxes. Northwest Lumber would adopt process D because, for every process up to and including D, the cost of switching to the next process would be less than the resulting tax saving. Overall, then, a tax of $101 per ton would result in the desired pollution reduction of 4 tons per day. The total cost of the reduction would be only $280 per day ($100 per day for Sludge Oil and $180 per day for Northwest Lumber), or $300 per day less than when each firm was required to cut its pollution by half. (The taxes paid by the firms do not constitute a cost of pollution reduction because the money can be used to reduce whatever taxes would otherwise need to be levied on citizens.)

RECAP POSITIONAL EXTERNALITIES Positional externalities occur when an increase in one person's performance reduces the expected reward of another person in situations in which reward depends on relative performance. Positional arms races are a series of mutually offsetting investments in performance enhancement that are stimulated by a positional externality. Positional arms control agreements are sometimes enacted in an attempt to limit positional arms races. In some cases, social norms can act as positional arms control agreements.

USING PRICE INCENTIVES IN ENVIRONMENTAL REGULATION As we have seen, goods whose production generates negative externalities, such as atmospheric pollution, tend to be overproduced whenever negotiation among private parties is costly. Suppose we decide, as a society, that the best attainable outcome would be to have half as much pollution as would occur under completely unregulated conditions. In that case, how should the cleanup effort be distributed among those firms that currently discharge pollution into the environment? The most efficient—and hence best—distribution of effort is the one for which each polluter's marginal cost of abatement is exactly the same. To see why, imagine that under current arrangements, the cost to one firm of removing a ton of pollution from the air is larger than the cost to another firm. Society could then achieve the same total reduction in pollution at lower cost by having the first firm discharge one ton more into the air and the second firm one ton less. Unfortunately, government regulators seldom have detailed information on how the cost of reducing pollution varies from one firm to another. Many pollution laws therefore require all polluters simply to cut back their emissions by the same proportion or to meet the same absolute emissions standards. If different polluters have different marginal costs of pollution abatement, however, these approaches will not be efficient.