Transcript Frank & Bernanke 3rd edition, 2007

Frank & Bernanke
rd
3 edition, 2007
Ch. 12: Externalities and
Property Rights
1
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
2
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.

3
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.

4
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.
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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.
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How External Costs
Affect Resource Allocation
Production with external cost
Production without external cost
Private MC
1,300
Price ($/ton)
Price ($/ton)
Social MC =
Private MC + XC
2,300
2,000
XC = $1,000/ton
Private MC
1,300
D
12,000
Quantity (tons/year)
D
Deadweight
loss caused by
pollution =
$2mil/yr
8,000
Social
optimum
12,000
Private
equilibrium
Quantity (tons/year)
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A Good Whose Production Generates a
Positive Externality for Consumers
• Without external benefits
QPVT is the social optimum
XB
Price
MBPVT + XB
MC
• With external benefits the
private D < social D and the
private optimum is less than
the social optimum
MBSOC
MBPVT
Social demand =
Private Demand + XB
Private Demand
Deadweight loss from
positive externality
Qpvt
QSOC
Quantity
8
Costs and Benefits of
Eliminating Toxic Waste
With filter
Without filter
Gains to
Abercrombie
$100/day
$130/day
Gains to
Fitch
$100/day
$50/day
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
Assume Fitch and
Abercrombie can
communicate at no cost
Fitch offers
Abercrombie $40 to use
the filter
Economic surplus
increases by $20
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The Coase Theorem

When a market leaves cash on table there
is usually a response to capture the
unrealized value.
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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.
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Example
By law Abercrombie cannot dump without
Fitch’s approval.
 Fitch and Abercrombie can negotiate
without cost.

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Costs and Benefits of
Eliminating Toxic Waste
With filter
Without filter
Gains to
Abercrombie
$100/day
$150/day
Gains to
Fitch
$100/day
$70/day
•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
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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.

14
The Optimal Amount of Negative
Externalities is Not Zero
MC/MB
MC (increasing
opportunity cost)
Optimal amount of
pollution: MC = MB
MC = MB
MB (diminishing
marginal utility)
Dirty environment
Q
Pollution free
Quantity of Pollution
abated
15
Taxing a Negative Externality
Private equilibrium
without pollution tax
Private equilibrium
with pollution tax
2,300
2,000
XC = $1,000/ton
Private MC
1,300
Private MC + Tax
Price ($/ton)
Price ($/ton)
Social MC =
Private MC + XC
Tax = $1,000/ton
2,000
Private MC
1,300
D
8,000
Social
optimum
12,000
Private
equilibrium
Quantity (tons/year)
D
8,000 12,000
Quantity (tons/year)
16
Subsidizing a Positive Externality
Private equilibrium
without subsidy
Private equilibrium
with subsidy
Social
optimum
Price ($/ton)
XB = 6
14
Subsidy = 6
MC
10
8
14
MC
10
Social demand =
8
Private demand + XB
Subsidized demand =
Private demand +
subsidy
Private
demand
1,200 1,600
Quantity (tons/year)
Private
demand
1,200 1,600
Quantity (tons/year)
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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

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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.

19
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.
20
Payoff Matrix for
Steroid Consumption
Jones
Don’t take
steroids
Smith
Don’t take
steroids
Take
steroids
Take
steroids
Second best for each
Best for Jones
Worst for Smith
Best for Smith
Worst for Jones
Third best for each
•Dominant strategy for each yields the third best outcome
•This prisoner’s dilemma outcome is the attraction of rules
banning performance enhancing drugs.
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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
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