Frank & Bernanke 3 rd edition, 2007

1. Frank & Bernanke3rd edition, 2007 Ch. 12: Externalities and Property Rights

2. External Costs and Benefits • External Cost (negative externality) • A cost of an activity that falls on people other than those who pursue the activity • External Benefit (positive externality) • A benefit of an activity received by people other than those who pursue the activity

3. External Costs and Benefits • How Externalities Affect Resource Allocation • Externalities reduce economic efficiency. • Solutions of externalities may be efficient. • When efficient solutions to externalities are not possible, government intervention or other collective action may be used.

4. How Externalities Affect Resource Allocation • Does the honeybee keeper face the right incentives? (Part I) • Bees pollinate the apple orchards. • The honeybee keeper may not consider the external benefit to the apple growers when considering the optimal number of hives. • If the external benefit is not considered, the bee keeper’s optimal number of hives will be less than the socially optimal number of hives.

5. How Externalities Affect Resource Allocation • Does the honeybee keeper face the right incentives? (Part II) • If the hives are located near a school and nursing home, additional hives will cause more people to get stung by the bees. • For the students and nursing home residents, the bee hives create an external cost. • If the external costs are not considered, the optimal number of hives for the beekeeper will be greater than the socially optimal number of hives.

6. How Externalities Affect Resource Allocation • When an activity does not create an externality, the optimal level of the activity for the individual will equal the socially optimal level of the activity. • When an activity generates a negative externality, the level of the activity will be greater than the socially optimal level. • When an activity generates a positive externality, the level of the activity will be less than the socially optimal level.

7. Social MC = Private MC + XC 2,300 XC = $1,000/ton PrivateMC 2,000 Private MC 1,300 1,300 D D Deadweight loss caused by pollution = $2mil/yr 12,000 8,000 12,000 Social optimum Private equilibrium How External Costs Affect Resource Allocation Production with external cost Production without external cost Price ($/ton) Price ($/ton) Quantity (tons/year) Quantity (tons/year)

8. Without external benefits QPVTis the social optimum XB • With external benefits the private D < social D and the private optimum is less than the social optimum MBPVT + XB MC MBSOC MBPVT Social demand = Private Demand + XB Private Demand Qpvt QSOC Deadweight loss from positive externality A Good Whose Production Generates a Positive Externality for Consumers Price Quantity

9. Costs and Benefits of Eliminating Toxic Waste With filter Without filter Gains to Abercrombie Gains to Fitch Assume Fitch and Abercrombie can communicate at no cost Fitch offers Abercrombie $40 to use the filter Economic surplus increases by $20 • The Market • Without filter: Total Gains = $130 + $50 = $180 • With filter: Total Gains = $100 + $100 = $200 • MC of the filter = $30 & MB of the filter = $50 • Loss in economic surplus = $20

10. The Coase Theorem • When a market leaves cash on table there is usually a response to capture the unrealized value.

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

12. Example • By law Abercrombie cannot dump without Fitch’s approval. • Fitch and Abercrombie can negotiate without cost.

13. Costs and Benefits of Eliminating Toxic Waste With filter Without filter Gains to Abercrombie Gains to Fitch • Economic surplus = $200 w/filter & $220 w/o filter • Fitch would gain $30 with the filter but the outcome is inefficient • Abercrombie pays Fitch $40 to operate without the filter • Economic surplus = $110 + $110 = $220 & both gain $10 • Allowing pollution increases economic surplus

14. Legal Remedies for Externalities • When negotiation is costless: • Efficient solutions to externalities can be found. • The adjustment to the externality is usually done by the party with the lowest cost. • When negotiation is not costless: • Laws may be used to correct for externalities. • The burden of the law can be placed on those who have the lowest cost.

15. MC (increasing opportunity cost) Optimal amount of pollution: MC = MB MC = MB MB (diminishing marginal utility) Q The Optimal Amount of Negative Externalities is Not Zero MC/MB Dirty environment Pollution free Quantity of Pollution abated

16. Private equilibrium without pollution tax Private equilibrium with pollution tax Social MC = Private MC + XC Private MC + Tax 2,300 XC = $1,000/ton Tax = $1,000/ton 2,000 2,000 Price ($/ton) Price ($/ton) Private MC Private MC 1,300 1,300 D D 8,000 Social optimum 12,000 Private equilibrium 8,000 12,000 Quantity (tons/year) Quantity (tons/year) Taxing a Negative Externality

17. Private equilibrium without subsidy 14 MC Price ($/ton) 10 Social demand = Private demand + XB 8 Private demand 1,200 1,600 Quantity (tons/year) Quantity (tons/year) Subsidizing a Positive Externality Private equilibrium with subsidy Social optimum XB = 6 Subsidy = 6 14 MC 10 Subsidized demand = Private demand + subsidy 8 Private demand 1,200 1,600

18. Tragedy of Commons • The Problem of “Free” Resources • When no one owns property, the opportunity cost of using it is not considered. • Use of the property will increase until MB = 0. • One person’s use of the commons imposes an external cost on the others by making the property less valuable. • If the common property is privatized (auctioned) opportunity cost of additional use will be considered by the owner

19. Tragedy of Commons • The Effect of Private Ownership • Zoning laws and other regulations restrict the use of private property. • The laws can be used to maximize economic surplus. • The laws can also be used to achieve an individual goal (reelection) by reducing the economic surplus. • Private ownership may be impractical because MB<MC.

20. Positional Externality • When an increase in one person’s performance reduces the expected reward of another in situations in which reward depends on relative performance • In a competitive situation: • There is an incentive to take an action to increase the odds of winning. • The overall gain to the players as a group will be zero. • When the payoff depends on relative performance, incentive to invest in performance activities will be excessive from a collective point of view.

21. Payoff Matrix forSteroid Consumption Jones Don’t take steroids Take steroids Don’t take steroids Smith Take steroids • Dominant strategy for each yields the third best outcome • This prisoner’s dilemma outcome is the attraction of rules banning performance enhancing drugs.

22. Positional Arms Race • A series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality • Positional Arms Control Agreements • An agreement in which contestants attempt to limit mutually offsetting investments in performance enhancements