Chapter 9 - Externalities and Property. In chapter 9 we will investigate how the allocation of resources is affected when activities generate costs or benefits that accrue to people not directly involved in those activities. We will see that if parties cannot easily negotiate with one another, the selfserving actions of individuals will not lead to efficient outcomes.
Externalities and Property Rights Chapter 10 McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved.101 Learning Objectives Define negative and positive externalities and analyze their effect on resource allocations Discuss and explain the Coase Theorem Explain how the effects of externalities can be remedied and discuss why the optimal amount of an externality is almost never zero Illustrate the tragedy of the commons and show how private ownership is a way of preventing it Define positional externalities and their effects, and show how they can be remedied 102 External Costs and Benefits • An external cost is a cost of an activity that falls on people other than those who pursue the activity – • • Also called a negative externality An externality is the name given to an external cost or external benefit of an activity An external benefit is a benefit of an activity received by people other than those who pursue the activity – Also called a positive externality 103 Externalities Affect Resource Allocation • Externalities reduce economic efficiency – – Solutions to externalities may be efficient When efficient solutions to externalities are not possible, government intervention or other collective action may be used 104 Honeybee Keeper – Scenario • Phoebe harvests and sells honey from her bees Bees pollinate the apple orchards – • • No payments made to Phoebe The bees provide a free service to the local farmers Phoebe is giving away a service – • Private costs are equal to private benefits – Social costs are less than social benefits When external benefits exist, maximizing private profits produces less than the social optimum 105 Honeybee Keeper – Scenario • • • Phoebe harvests and sells honey from her bees People at a neighboring school and nursing home are bothered by bee stings The bees are a nuisance to the neighbors Phoebe is not paying all the costs of her honeybees – • Private costs are equal to private benefits – Social costs are greater than social benefits When external costs exist, maximizing private profits produces more than the social optimum 106 External Costs External Cost Private MC 1.3 D 2.0 2.3 12,000 Quantity (tons/year) Social MC Price ($000s / ton) Price ($000s / ton) No External Cost $1,000/ton 1.3 Private MC D 12,00 8,000 Quantity (tons/year) Deadweight loss from pollution = $2 M/yr Social Optimum Private Equilibrium 107 Positive Externality for Consumers Deadweight loss from positive externality XB Price MC MBPVT + XB MBSO C MBP VT Private Equilibrium Social Demand QP QSO VT QuantityC Private Demand Social Optimum 108 Effects of Externalities With externalities, private market outcomes not achieve the largest possible economic surplus Cash is left on the table 109 Remedying Externalities • With externalities, private market outcomes not achieve the largest possible economic surplus – • For example, with monopolies, output is lower than with prefect competition – • Cash is left on the table Introduction of coupons and rebates expands the market With externalities, actions to capture the surplus are likely 1010 Taxes and Subsidies • When transaction costs prohibit negotiation: – – • • Negative externalities result in overproduction Positive externalities result in underproduction A per unit tax on output can move the market to the socially optimal output when there is a negative externality A per unit subsidy on output can move the market to the socially optimal output when there is a positive externality 1027 Taxing a Negative Externality 1.3 Social MC XC Private MC 2.0 Price ($000s / ton) 2.3 2.0 Price ($000s / ton) No Pollution Tax Pollution Tax $1,000 Private MC/ + Tax ton 1.3 Tax Private MC D D 8,000 Social Optimum 12,00 Quantity (tons/year) Private Equilibrium 8,000 12,000 Quantity (tons/year) After Tax Equilibrium Before Tax Equilibrium 1028 Subsidizing a Positive Externality 14 MC XB 10 Social Demand Subsidy 14 Price ($ / ton) Price ($ / ton) No Subsidy Subsidy 10 Subsidized Demand Private Demand 1216 Quantity (000s tons/year) MC Private Demand 1216 Quantity (000s tons/year) 1029 Tragedy of Commons • When use of a communally owned resource has no price, the costs of using it are not considered – – • Use of the property will increase until MB = This is known as the tragedy of the commons Suppose villagers own land suitable for grazing – – – – Each can spend $100 for either a steer or a government bond that pays 13% Villagers know what everyone before them has done Steer graze on the commons Value of the steer in year depends on herd size 1030 Payoff For a Steer • • Using the information in the table below, each villager makes a decision Selling Price per Steer Income per Steer 126 26 119 19 116 16 113 13 111 11 The fourth is indifferent between the two assets – • # Steers He buys a steer The fifth buys a bond 1031 What the Villagers Did • The village has steer feeding on the commons for one year – • Total revenue for the village is (5) (113) = $565 – • At the end of the year, steer sell for $113 each Outcome is the same as bonds They could have done better 1032 A Better Choice § § § # Steer Selling Price Income per steer Total Cattle Income Marginal Income 126 26 26 26 119 19 38 12 116 16 48 10 Net income from one bond after one year is $13 § Buy a steer only if its marginal benefit is at least $13 First villager buys a steer and all others buy bonds § Total net income is 26 + (4) (13) = $78 § A net gain of $13 compared to the first scenario Tragedy of the commons is the tendency for a resource that has no price to be used until its marginal benefit is zero 1033 The Effect of Private Ownership • The villagers decide to auction off the rights to the commons – – – • Auction makes the highest bidder consider the opportunity cost of grazing additional steer Villagers can borrow and lend at 13% One steer is the optimal number Winning bidder pays $100 for the right to use the commons 1034 The Effect of Private Ownership • The winning bidder starts the year Spends $100 in savings to buy a yearling steer Borrows $100 at 13% to get control of commons – – • The winning bidder ends the year Sells the steer for $126 – • • • • Gets original $100 back $13 opportunity cost of buying a steer $13 interest on loan for the commons Economic surplus of the village is (4 x $13) + $26 = $78 1035 Property Rights and the Tragedy of Commons Blackberries in the Park Sweetness increases as the berry ripens • Blackberries are common property • – Berries will be eaten before they are fully ripe Other Examples • Harvesting – – • Shared Milkshakes • Milkshakes chill taste buds – – • Decrease appreciation of its flavor Drinking slowly increases appreciation If two people share the milkshake, it is a common good – They will drink faster than if it were a private good Timber on remote public land Whales in open oceans Worldwide pollution controls 1036 Positional Externalities • 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 > collective payoff – • Total payout is fixed, so players' group has no gains 1037 Football Players Take Steroids • • Smith and Jones compete for one $1 million contract – Each has 50% chance at the contract Smith and Jones have a Prisoner's Dilemma Jones's Options Smith's Options No Steroids Steroids No Steroids 2nd best for each Best for Smith Worst for Jones Steroids Worst for Smith Best for Jones 3rd best for each 1038 Positional Externalities • Relative performance determines reward – • 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 – A positional arms control agreement attempts to limit the mutually offsetting investments in performance enhancements by contestants 1039 Examples of Positional Arms Control Agreements • • • • • Campaign spending limits Roster limits Arbitration agreements Mandatory starting dates for kindergarten Social Norms as Positional Arms Control Agreements – – – – Nerd norms Fashion norms Norms of taste Norms against vanity 1040 Externalities and Property Rights Effects of External Costs Tragedy of the Commons Externalities and Property Rights Effects of External Benefits Remedies Coase Theorem Positional Externalities Laws Taxes & Subsidies 1041 ... government yearly • Externalities of new knowledge 10 25 Optimal Amount of Negative Externalities MC & MB MC Optimal amount of pollution MC = MB MB Q Quantity of Pollution 10 26 Taxes and Subsidies •... 1216 Quantity (000s tons/year) 10 29 Tragedy of Commons • When use of a communally owned resource has no price, the costs of using it are not considered – – • Use of the property will increase... Abercrombie's Gains $100 / day $150 / day Fitch's Gains $100 / day $70 / day Total Gains $200 / day $220 / day 10 17 Shared Living • • • Ann and Betty are evaluating housing options – 2-bedroom apartment