Chapter 11
Externalities and Property
Rights
Additional Questions,
Q. 2, 3, 4, 10
Externalities
• Negative Externality:
• “a cost of an activity falls on people other than those
who pursue the activity.”
• i.e., a person smokes near you, you breathe in
second-hand smoke .
• Individuals who consider only their own costs and
benefits will tend to engage too much in activities
that generate negative externalities.
• Thus, the private equilibrium quantity is more than
the social equilibrium quantity
• QPVT > QSOC
Externalities
• Positive Externality:
• “a benefit of an activity received by people other
than those who pursue the activity.”
• i.e., a person take a flu shot, it reduces the chances
of infection.
• Individuals who consider only their own costs and
benefits will tend to engage too little in activities that
generate positive externalities.
• Thus, the private equilibrium quantity is less than the
social equilibrium quantity
• QPVT < QSOC
Externalities
• Negative and positive externalities create
deadweight loss.
• It results in a loss in economic efficiency.
Externalities
• Tax and subsidy is a way to increase economic
efficiency resulting from externalities.
• They induce producers to take account of a
relevant benefit and cost that they otherwise
would have ignored.
• Thus, the private MB curve becomes the social
MB curve; and the private MC curve becomes
the social MC curve.
• As a result, improving economic efficiency and
reducing the deadweight loss
Chapter 11, Problem 2
Phoebe keeps a bee farm next door to an apple orchard. She
chooses her optimal number of beehives by selecting the honey
output level at which her private marginal benefit from beekeeping
equals her private marginal cost.
a) Assume that Phoebe’s private marginal benefit and marginal
cost curves from beekeeping are normally shaped. Draw a diagram
of them.
a) Assume that Phoebe’s private marginal benefit and marginal cost
curves from beekeeping are normally shaped. Draw a diagram of
them.
$/hive
Private MC
Ppvt
Private MB
Qpvt
Number of beehives
No external cost and benefit is involved.
The equilibrium price and quantity is socially optimal.
b) Phoebe’s bees help to pollinate the blossoms in the apple orchard,
increasing the fruit yield. Show the social marginal benefit from
Phoebe’s beekeeping in your diagram.
$/hive
DWL
Private MC
Ppvt + XB
P Soc
Ppvt
XB
Social MB = Private MB + XB
Private MB
Qpvt
QSoc
Number of beehives
External benefit (positive externality) is involved in this case.
The private market is producing too little.
c) Phoebe’s bees are Africanized killer bees that aggressively sting
anyone who steps into their flight path. Phoebe, fortunately, is
naturally immune to the bees’ venom. Show the social marginal
cost curve from Phoebe’s beekeeping in your diagram.
Social MC = Private MC + XC
$/hive
XC Private MC
Ppvt + XC
P Soc
Ppvt
Private MB
QSoc
Qpvt
Number of beehives
External cost (negative externality) is involved in this case.
The private market is producing too much.
d) Indicate the socially optimal quantity of beehives on your diagram,
Is it higher or lower than the privately optimal quantity? Explain.
•
If we combine the positive and negative externality, the socially
optimal number of beehives could be greater or less than the
privately optimal number
•
depending on the magnitude of the social marginal cost relative to
the private marginal cost; and
•
depending on the magnitude of the social marginal benefit relative
to the private marginal benefit.
If the negative externality is negligible and the positive externality is
large:
Social MC
$/hive
Private MC
Social MB
Private MB
Q pvt
Q soc Number of beehives
The socially optimal number of beehives, Qsoc , exceeds the privately
optimal number, Qpvt.
If the negative externality is large and the positive externality is
negligible:
Social MC
$/hive
Private MC
Social MB
Private MB
Q soc Q pvt
Number of beehives
The socially optimal number of beehives, Qsoc , is smaller than the
privately optimal number, Qpvt.
Chapter 11, Problem 3
Suppose the supply curve of boom box rentals in Golden Gate
Park is given by P = 5 + 0.1Q, where P is the daily rent per unit
in dollars and Q is the volume of units rented in hundreds per
day. The demand curve for boom boxes is 20 – 0.2Q. If each
boom box imposes $3 per day in noise costs on others, by
how much will the equilibrium number of boom boxes rented
exceed the socially optimal number?
• Negative Externality
P = 8 + 0.1Q
$/unit
20
XC
P = 5 + 0.1Q
PSOC
Ppvt
8
5
Q SOC Q pvt
Market Equilibrium:
5 + 0.1Q = 20 – 0.2Q
Q pvt = 50
P pvt = 10
P = 20 – 0.2Q
Number of rentals
• Imposition of $3 noise cost (external cost):
• Social supply curve = original supply curve + 3
• Social supply curve = 8 + 0.1Q
8 + 0.1Q = 20 – 0.2Q
Q pvt = 40
P pvt = 12
• If the negative externality (noise) is internalized into the rental, the equilibrium
rental is greater than the social equilibrium rental by 10 (50 – 40)
Chapter 11, Problem 4
Refer to problem 3. How would the imposition of a tax of $3
per unit on each daily boom box rental affect efficiency in this
market?
• Tax is a way to increase economic efficiency resulting from externalities.
• Tax forces the producers to take into account the costs impose on others.
• Tax has the effect of raising each producer’s MC curve by the same
amount as the external cost; therefore, Private MC shifts up and equals to
the Social MC.
• Thus, the resulting private equilibrium quantity equals to the socially
optimal quantity.
• The government can use taxes as an incentive for producers to cut back on
externalities, i.e. pollution.
• Taxes used in this way are called Pigou taxes.
• By setting the tax rate equal to the marginal external cost, firms can be
made to behave in the same way as they would if they bore the cost of
externality directly.
• Thus, the imposition of a $3 per unit tax is efficiencyenhancing
• It actually internalizes the noise cost into the private supply
curve
• After the imposition of tax, the supply curve becomes the
social supply curve
• It helps bring the inefficient rental of boom boxes to the
(socially) efficient rental of boom boxes
Additional Question
• Affordable housing is seen as a way to reduce crime
rates and raise the quality of life of lower income
neighborhoods.
• A) Given this information, what economic concept
do you think is relevant to the analysis of the
affordable housing market?
• Affordable housing gives a positive externality
• It reduces the crime rates and raises the quality of
life of other people in the neighborhood
• Therefore, the marginal social benefit of affordable
housing is greater than the marginal private benefit
for owners of affordable housing
• B) Graphically show the market for affordable
housing. What is the market equilibrium? What is
the social optimum?
• C) Graphically show any deadweight loss in this
market.
• As the marginal social benefit is greater than the
marginal private benefit for affordable housing, the
equilibrium quantity from a competitive market at Q1
is lower than the socially optimal quantity of Q2.
DWL
P2
P1
• D) Discuss potential ways of reducing deadweight loss in this
market.
• To reduce deadweight loss in this market, the government can subsidize
the ownership of affordable housing by the same amount as the external
benefit, so that the number of affordable homes increases toward Q2
• Subsidy is a way to increase economic efficiency resulting from
externalities.
• It induces producers to take account of a relevant benefit that they
otherwise would have ignored.
• Subsidy has the effect of raising each producer’s MB curve by the same
amount as the external benefit; therefore, Private MB shifts up and equals
to the Social MB.
• Thus, the resulting private equilibrium quantity equals to the socially
optimal quantity
Chapter 11, Problem 10
A village has six residents, each of whom has accumulated savings
of $100. Each villager can use this money either to buy a
government bond that pays 15 percent interest per year or to buy a
year-old llama, send it onto the commons to graze, and sell it after
1 year. The price the villager gets for the 2-year-old llama depends
on the quality of the fleece it grows while grazing on the commons.
That in turn depends on the animal’s access to grazing, which
depends on the number of llamas sent to the commons, as shown in
the following table:
Number of llamas on the commons
Price per 2-year-old llama($)
1
122
2
118
3
116
4
114
5
112
6
109
The villagers make their investment decisions one after another, and their
decisions are public.
a) If each villager decides individually how to invest, how many llama
will be sent onto the commons, and what will be the resulting net
village income?
He will send llama onto the commons if the benefit is at least as
large as the interest he could have earned on government bonds.
Construct the table:
Number of
llamas on the
commons
Price per 2year-old llama
($)
Income per
llama ($/yr)
Total village
income ($/yr)
1
122
(122 – 100) = 22
22
2
118
18
36
3
116
16
48
4
114
14
56
5
112
12
60
6
109
9
54
To buy a $100 government bond, $15 of interest will be earned, or
$115 in total.
Villager should send a llama on the commons if and only if that llama
will command a price of at least $115.
Therefore, 3 llamas will be sent onto the commons, 3 villagers will buy
the government bond.
Total village income: $48 + 3($15) = $93
b) What is the socially optimal number of llamas for this village? Why
is that different from the actual number? What would net village
income be if the socially optimal number of llamas were sent onto
the commons?
•
To maximize the income received by the group as a whole.
•
We need to compare the marginal income.
•
Recall, the amount that could be earned from a government bond
is $15.
•
Villagers should send llama onto the commons only if its marginal
income is at least as large as $15.
Number of
llamas on the
commons
Price per 2year-old
llama ($)
Income per
llama ($/yr)
Total village
income ($/yr)
Marginal
income ($/yr)
1
122
22
22
22
2
118
18
36
14
3
116
16
48
12
4
114
14
56
8
5
112
12
60
4
6
109
9
54
-6
The socially optimal number is to send 1 llama onto the commons and buy 5 government
bonds; instead of sending 3 llamas onto the commons and buy 3 government bonds as in
part a.
This is different from the actual number because in deciding whether or not to send a llama,
each villager ignores the impact of his llama’s presence on the other llamas’ fleece quality.
The total village income would then be $22 + 5($15), $97.
That amount is $4 more than the total amount that resulted when villagers made their
investment decisions individually.
c) The village committee votes to auction the right to graze llamas on
the commons to the highest bidder. Assuming villagers can both
borrow and lend at 15 percent annual interest, how much will the
right sell for at auction? How will the new owner use the right,
and what will be the resulting village income?
•
If a single villager could control access to the commons, the most
profitable way to use this land is to send only a single llama, and
earn $22 per year.
•
The opportunity cost of $100 spend on llama is the interest could
have earned from buying government bond, $15.
•
If the land were free, the owner would thus earn $22 per year by
raising one llama per year on it, or $7 more than she would have
earned had she used her $100 to buy a bond.
• The price of the land will be bid up until it owning the land is no
better than putting the same amount in the bank at 15 percent
interest.
•
That price is the amount of money that would yield $7 per year if
deposited at 15 percent interest, that is,
0.15x = 7
x= $46.67
• Therefore, the new owner will graze one llama.
• The village income will be $97; $22 + 5($15).
Additional Question # 1
A cost or benefit that falls on people other
than those pursuing an activity is called a(n)
a)
b)
c)
d)
e)
positive externality.
negative externality.
externality.
external cost.
external benefit
Ans: C
Additional Question # 2
Which of the following is an example of a
negative externality?
a)
b)
c)
d)
e)
Your neighbors enjoying the loud music you play.
A firm dumping waste into a stream.
Bees pollinating flowers on adjacent property.
Whales swimming in international waters.
None of the above.
Ans: B
Additional Question # 3
A negative externality will result in an equilibrium quantity of
an activity that is _____________ the socially optimal
quantity.
a)
b)
c)
d)
e)
above
below
above or below
equal to
it can not be determined
Ans: A
Additional Question # 4
A positive externality will result in an equilibrium quantity of
an activity that is _____________ the socially optimal
quantity.
a)
b)
c)
d)
e)
above
below
above or below
equal to
it can not be determined
Ans: B
Additional Question # 5
Which factor, if it were present, would lessen the ability of
the Coase Theorem to solve an externality?
A)
B)
C)
D)
E)
The situation is already efficient.
Negotiating requires hiring a lawyer.
The parties are all self-interested.
The potential gain in surplus is high.
Property rights have already been assigned to one of the
parties.
Ans:
B
• 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
the problems causes by externalities.”
• Hiring a lawyer is a kind of transaction costs – one has to
spend time to find a lawyer, as well as paying the lawyer to do
the negotiation. In other words, in order to exercise one’s
right, the person has to incur some transaction costs.
• Therefore, Option B is the answer.
Additional Question # 6
• Suppose there are ten people playing cards in a room. One of
them wants to smoke a cigar; nine of them dislike the smell of
cigar smoke. The smoker values the privilege of smoking at
$5, and each of the other nine occupants of the room would
be willing to pay fifty cents for clean air in the room. The rules
governing use of the room state that smoking is not allowed
unless everyone agrees to allow smoking.
If the cigar smoker paid each other occupant $0.50
for the right to smoke, the cigar smoker would be
? and the other occupants would be ? .
A)
B)
C)
D)
E)
Better off; worse off.
Better off; just as well off as before the payment.
Better off; better off.
Just as well off as before the payment; better off.
Worse off; just as well off as before the payment.
• According to the story:
– The smoker’s reservation price for smoking is $5.
– Each of other occupants’ reservation price for clean air is
$0.50.
• Now the smoker is paying to compensate the other occupants
from the smoky air.
• There are 9 other occupants. Each of them is paid $0.50,
which is their reservation price.
• Before the payment, they were enjoying clean air which was
valued also at $0.50.
• Therefore, they are equally well off as before the payment.
• The smoker’s reservation price for a drag is $5.
• He is paying $0.50 x 9 to smoke, which amounts to $4.50.
• There is a $0.50 surplus.
• Hence, he is better off.
• Ans:B
Additional Question # 7
The reason drivers would prefer building new roads
to a $5 toll to reduce commute times is because
A)
B)
C)
D)
E)
Building roads is the only solution.
They know a toll would not alter commuting behaviour.
Cities always need new roads.
The cost of new roads falls on all taxpayers; the toll only
falls on those who use the existing road.
Of the commitment problem.
Ans: D
• Options A and B are not right. We know that
by setting a toll, the congestion on the
highway can be reduced (and solved entirely).
• Option C does not make any economic sense
at all.
• Option E is also not right, as we are not talking
about competition or game theory.
• If a toll of $5 is imposed, users of the highway
will have to pay money out from their pocket
on a ‘pay as you use’ basis.
• Which means the users will have to pay for
what they use.
• This is not a problem until rational consumers
realise that they can actually shift the financial
burden to other people, spreading the
contribution among all people in the city.
• By having the government building more roads, all
taxpayers in the cities are financing the project.
• Probably not all taxpayers are users of that highway
anyway.
• Frequent highway users will find out that instead of
paying $5 every single day, commuting on other
people’s money (including theirs, but the cost is
spread) is a bargain.
• And hence, Option D is the answer.
Additional Question # 8
• Explain the following situations by using the concept
“Tragedy of the commons”.
a)
b)
c)
d)
Harvesting timber on public land
Picking strawberries in a public park
Harvesting whales in international oceans
Environmental pollution
• “Tragedy of the commons” the tendency for a resource that
has no price to be used until its marginal benefit falls to zero.
• When no one has the private ownership to own any kind of
property, i.e., land, ocean, swimming pool, he/she has no
incentive to take the opportunity cost of using it into account.
• The cause of it is the fact that one person’s use of commonly
held property imposes an external cost on others by making
the property less valuable.
• Solutions to the tragedy of commons are to place a clearly
defined property ownership and to place a regulation of the
use of property.
a) Harvesting timber on public land
• Each tree cutter knows that a tree 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 will.
• Solution: Laws regulated the amount of harvests
b) Picking strawberries in a public park
• Each individual knows that the strawberries would taste
better if allowed to ripen for another week
• But each also knows that strawberries not eaten today may
not be there next week.
• Solution: assign ownership on strawberries park
c) Harvesting whales in international oceans
• Each individual whaler knows that harvesting an extra whale
reduces the breeding population of whales
• Hence reduce the size of future whale populations, but he
also knows that any whale he fails to harvest today will just be
taken by some other whaler.
• Solution: Fishing license
d) Environmental pollution
• Each individual polluter has no incentive to take into account
the cost his pollution imposes on others.
• Solution: Tax
Additional Question # 9
People can purchase and sell the right to perform
activities that cause externalities to arrive at efficient
solutions. This describes
a)
b)
c)
d)
e)
the Tragedy of the Commons.
a positional externality.
an external benefit.
the Coase Theorem.
the problem of unpriced resources.
Ans: D