Introductory Microeonomics

1. Introductory Microeonomics Externalities and Property Rights

2. Externalities • Sometimes costs or benefits that result from an activity accrue to people not directly involved in the activity. • These are called external costs or external benefits-- externalities for short.

3. Example 12.1. • Sara is an accomplished classical violinist. • Her neighbor Tom is a fan of classical violin music, and on summer evenings enjoys listening to Sara play in her garden. • For Tom, Sara's music is a positive externality. • If Sara plays only in response to her own costs and benefits, will the amount of time she plays be socially optimal?

4. Example 12.1. • If Sara plays in response to her own costs and benefits, she will continue to play until the marginal benefit of playing another minute is equal to the marginal cost. • But since Tom also benefits from her playing, at that point the total marginal benefit of playing another minute will be greater than the marginal cost.

5. Example 12.1. • Thus, if Sara plays in response to her own costs and benefits, Sara plays too little.

6. Example 12.2. • Sara is an accomplished classical violinist. • Her neighbor Harry hates the sound of violin music, and on summer evenings becomes distressed when Sara plays in her garden. • For Harry, Sara's music is a negative externality. • If Sara plays only in response to her own costs and benefits, will the amount of time she plays be socially optimal?

7. Example 12.1. • If Sara plays in response to her own costs and benefits, she will continue to play until the marginal benefit of playing another minute is equal to the marginal cost. • But since Harry also incurs costs from her playing, at that point the marginal benefit of playing another minute will be greater than their combined marginal costs.

8. Example 12.2. • Thus, if Sara plays in response to her own costs and benefits, Sara plays too much.

9. Externalities and activity • Negative externalities => too much activity • Positive externalities => too little activity

10. Example 12.3. • Smith can produce with or without a filter on his smokestack. • Production without a filter results in greater smoke damage to Jones.

11. Example 12.3. If Smith is not liable for smoke damages and if the two parties can negotiate costlessly with one another, will he install a filter?

12. Example 12.3. Total economic surplus goes up if Smith installs the filter: $200-$35=$165 > $245-$85=$160. The filter costs $245-$200=$45. Smith doesn't have to install it, but if Jones pays him at least $45, he will gladly do so. And since the filter results in savings of $84-$35=$50 for Jones, he will pay Smith to install the filter.

13. The Coase Theorem If property rights are fully assigned and if people can negotiate costlessly with one another, they will always arrive at efficient solutions to problems caused by externalities. Ronald Coase: 1991 Nobel Laureate in Economics Additional readings: Posner, Richard A. (1993): “Nobel Laureate Ronald Coase and Methodology,” Journal of Economic Perspectives, 7(4): 195-210. “Of Bees and Lighthouses: Schools Brief,” The Economist, Feb 23, 1991, p.72.

14. Example 12.3. • Traditional (pre-Coase) view: • Smith is the perpetrator (the person who committed a crime), Jones is the victim. • If it is Smith's smoke that is causing the damage to Jones, why should Jones pay Smith to install a filter on his smokestack?

15. Example 12.3. • Coase’s insight was that externalities are purely reciprocal. • The smoke harms Jones, true enough. • But to restrain Smith from producing smoke would harm Smith. • The two parties have a shared interest in achieving the outcome that is least costly overall.

16. Benefit to all when the pie is larger

17. Example 12.4. Ted and Bill can live together in a two-bedroom apartment for $500/mo…

18. Example 12.4. …or each rent a one-bedroom apartment for $300/mo.

19. Example 12.4. If the rent were the same, they would be indifferent between living together or separately, except for one problem: Ted likes to practice his trumpet late at night and this will disturb Bill's sleep.

20. Example 12.4. • Ted would pay up to $150/mo rather than reschedule his playing. • Bill would pay up to $80 per month not to have his sleep disturbed. Will they live together or separately?

21. Example 12.4. • The question is whether the benefits of joint living exceeds the costs. • The benefit is the $100 per month reduction in rent. What is the least costly accommodation to the trumpet problem?

22. Example 12.4. • If they live together • Cost to Ted of stopping playing: $150/mo • Cost to Bill of tolerating the noise: $80/mo • So the least costly solution is for Bill to put up with the noise (since $80 < $150). • Since this cost ($80) is less than the $100/mo gain, they should live together.

23. Example 12.5. • In the preceding example, what is the largest rent Bill would be willing to pay if the two were to live together? If Bill were to live alone, he would pay $300/mo and suffer no trumpet noise. Since the noise costs him $80/mo, the most he would be willing to pay for the shared apartment is $300 - $80 = $220.

24. Example 12.6. • How should Ted and Bill split the $500/mo rent if they agree that each should benefit equally from living together? Their total gain from living together is $100 - $80 = $20/mo. If Ted pays $290/mo and Bill pays $210/mo, each will be $10/mo better off than if he were to live alone.

25. Costly negotiations • It is often impractical to negotiate solutions to the problems created by externalities. • Hospital patients, for example, are unable to negotiate with passing motorists about not blowing their horns. • In such cases, the law tries to impose the burden of adjustment on the party that can accomplish it at lowest cost.

26. Costly negotiations Not blowing his horn is a cost to the motorist, but a benefit to the patient. Because peace and quiet is especially valuable for hospital patients, the law prohibits horn blowing in the vicinity of hospitals.

27. Costly negotiations In non-hospital zones, the law is more liberal in its tolerance of noise. In many cities, there are 11 PM noise curfews on weekdays, midnight curfews on weekends. For those who are interested in law and economics: Bouckaert, Boudewijn and De Geest, Gerrit (eds.), Encyclopedia of Law and Economics, Cheltenham, Edward Elgar, 2000

28. Example 12.7.The Right to an Unobstructed View • Lehman owns a house overlooking the lake, from which he enjoys a commanding sunset view.

29. Example 12.7.The Right to an Unobstructed View • Now Martin purchases the property below Lehman's and is considering which of two houses to build: • a one-story house that would leave Lehman's view intact; • or a two-story design that would completely block Lehman's view.

30. Example 12.7.The Right to an Unobstructed View • Suppose the gain to Lehman from an unobstructed view is 100, the gain to Martin from having a one-story house is 200, and the gain to Martin from a two-story house is 280. • If the laws of property let people build houses of any height they chose, and if negotiation between property owners were costless, which of the two houses would Martin build?

31. Example 12.7.The Right to an Unobstructed View • Value of view to Lehman: 100 • Value of second story to Martin: 280-200=80 • The increase in Martin's gain from having the taller house is 80, which is 20 less than the cost to Lehman from the loss of his view. • The efficient outcome is thus for Martin to build the one-story house. • And that is exactly what would happen if the two parties could negotiate costlessly.

32. Example 12.7.The Right to an Unobstructed View • Rather than see Martin build the taller house, it will be in Lehman's interest to compensate Martin for choosing the shorter version. • To do so, he will have to give Martin at least 80. • The most Lehman would be willing to pay is 100, since that is all the view is worth to him. • For some payment P, where 80P100, Lehman will get to keep his view.

33. Example 12.7.The Right to an Unobstructed View • Suppose, however, that negotiations between the two parties were impractical. • Martin would then go ahead with the two-story house, since that is the version he values most. • By comparison with the one-story design, Martin would gain 80, but Lehman would lose 100. • The optimal structure of property rights in this particular example would be to prohibit any building that blocks a neighbor's view.

34. Example 12.7.The Right to an Unobstructed View • If the valuations assigned by the parties were different, a different conclusion might follow. • If, for example, Martin valued the two-story house at 300 and Lehman valued the view at only 80, the optimal structure of property rights would be to allow people to build to whatever height they chose.

35. Modified Coase Theorem • The optimal structure of property rights is the one that places the burden of adjustment (either the loss of a view or the loss of a preferred building design) on the party that can accomplish it at the lowest cost. • As a practical matter, the laws of property in many jurisdictions often embody precisely this principle.

36. Modified Coase Theorem • In cities like San Francisco, strict zoning laws prohibit construction that blocks an existing building's line of sight

37. Modified Coase Theorem • Zoning laws in cities where there is less to look at are generally much more liberal in the kinds of buildings they permit.

38. Modified Coase Theorem • But even in cities that have no special view to protect at all, zoning laws generally limit the fraction of the lot that can be occupied by manmade structures.

39. Example 12.8.Taxing Negative Externalities • Two firms, X and Y, have access to five different production processes, each one of which has a different cost and gives off a different amount of pollution. If pollution is unregulated, and negotiation between the firms and their victims is impossible, each firm will use A, the least costly of the five processes. Each will emit 4 tons of pollution per day, for a total pollution of 8 tons/day.

40. Example 12.8.Taxing Negative Externalities • The city council wants to cut smoke emissions by half. To accomplish this, they are considering two options. • Require each firm to curtail its emissions by half. • Set a tax of T on each ton of smoke emitted each day. How large would T have to be in order to curtail emissions by half? And how would the total costs to society compare under the two alternatives?

41. Example 12.8.Taxing Negative Externalities A: If each firm is required to cut pollution by half, each must switch from process A to process C. The result will be two tons/day of pollution for each firm. The cost of the switch for firm X will be 700/day-200/day=500/day. The cost to Y will be 140/day-50/day=90/day, So total cost for the two firms = 590/day.

42. Example 12.8.Taxing Negative Externalities B: How will each firm respond to a tax of T per ton of pollution? Switching to the next process will cut pollution by 1 ton per day and save tax of T/day. If cost of switching to the next process is less than or equal to T, it will switch, otherwise not.

43. Example 12.8.Taxing Negative Externalities • T= 50/ton: Firm X would stick with process A. Firm Y will switch to process B. A tax of 50/ton thus does not produce the desired 50 percent reduction in pollution.

44. Example 12.8.Taxing Negative Externalities • T= 91/ton. X will adopt process B, Y will adopt process D. Total emissions will be the desired 4 tons/day. Cost to firm X will be 290/day-200/day = 90/day. Cost to firm Y will be 230/day-50/day = 180/day. Total cost for both firms is thus only 270/day, or 320/day less than the cost of having each firm cut pollution by half.

45. Example 12.8.Taxing Negative Externalities • Note that the taxes paid by the firm are not included in our reckoning of the social costs of the tax alternative, because this money is not lost to society. • It can be used to reduce whatever taxes would otherwise have to be levied on citizens.

46. Example 12.9. Pollution Permits • Similar to the preceding example but now the government issues pollution permits to the two firms, allowing them to generate 4 tons of smoke daily, in total. • Will the pollution generated by the two firms change with the different allocation of permits?

47. Example 12.9. Pollution Permits • Similar to the preceding but now the government issues pollution permits to the two firms, allowing them to generate 4 tons of smoke daily, in total. • Suppose each firm is given permits to generate 2 tons of smoke. By moving from C to B, Firm X will generate 1 more ton of smoke but will save a cost of $410. By moving from C to D, Firm Y will incur a cost of $90. Negotiation will ensure the new allocation (3 tons for firm X, and 1 ton for firm Y)

48. The Tragedy of the Commons

49. Example 12.10 • A village has five residents, each of whom has accumulated savings of $100. • Each villager has two investment opportunities: • Buy government bond for $100 that pays 12% interest per year. • Buy a year-old steer for $100, send it onto the commons to graze, then sell it after one year.

50. Example 12.10 • The Relationship Between Herd Size, Selling Price, and Profit per Steer If each person decides individually how to invest, how many steers will be sent onto the commons?