Externalities and
Property Rights
MB
MC
MB MC
External Costs and Benefits

External Cost (negative externality)

A cost of an activity that falls on people
other than those who pursue the activity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 2
MB MC
External Costs and Benefits

External Benefit (positive externality)

A benefit of an activity received by people
other than those who pursue the activity
Copyright c 2007 by The McGraw-Hill
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Chapter 12: Externalities and Property Rights
Slide 3
MB MC
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.

Copyright c 2007 by The McGraw-Hill
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Chapter 12: Externalities and Property Rights
Slide 4
MB MC
External Costs and Benefits

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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 5
MB MC
External Costs and Benefits

How Externalities Affect Resource
Allocation

Does the honeybee keeper face the right
incentives? (Part I)
 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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 6
MB MC
External Costs and Benefits

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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 7
MB MC
External Costs and Benefits

How Externalities Affect Resource
Allocation

Does the honeybee keeper face the right
incentives? (Part II)
 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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 8
MB MC
External Costs and Benefits

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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 9
MB MC
External Costs and Benefits

How Externalities Affect Resource
Allocation

When an activity generates a negative
externality, the level of the activity will be
greater than the socially optimal level.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 10
MB MC
External Costs and Benefits

How Externalities Affect Resource
Allocation

When an activity generates a positive
externality, the level of the activity will be
less than the socially optimal level.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 11
MB MC
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)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 12
A Good Whose Production Generates
a Positive Externality for Consumers
MB MC
• Without external benefits
QPVT is the social optimum
• With external benefits the
private D < social D and the
private optimum is less than
the social optimum
XB
Price
MBPVT + XB
MC
MBSOC
MBPVT
Social demand =
Private Demand + XB
Private Demand
Deadweight loss from
positive externality
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Qpvt
QSOC
Quantity
Chapter 12: Externalities and Property Rights
Slide 13
MB MC
External Costs and Benefits

The Coase Theorem

When a market leaves cash on table there
is usually a response to capture the
unrealized value.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 14
MB MC
External Costs and Benefits

Example

Will Abercrombie dump toxins in the river
(Part I)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 15
MB MC
External Costs and Benefits

Example

The Market
 Abercrombie’s
company produces a toxic
waste.
 If the waste is dumped into the river, Fitch
cannot fish the river.
 Should Abercrombie install a filter?
o Assume there is no communication between
Abercrombie and Fitch
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 16
MB MC
Costs and Benefits of
Eliminating Toxic Waste (Part 1)
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
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 17
MB MC
Costs and Benefits of
Eliminating Toxic Waste (Part 2)
With filter
Without filter
Gains to
Abercrombie
$100/day
$130/day
Gains to
Fitch
$100/day
$50/day
Assume
•Fitch and Abercrombie can communicate at no cost
•Fitch offers Abercrombie $40 to use the filter
•Economic surplus increases by $20
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 18
MB MC
External Costs and Benefits

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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 19
MB MC
External Costs and Benefits

Question

Why should Fitch pay Abercrombie to filter
out toxins that would not be there in the
first place if not for Abercrombie’s factory?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 20
MB MC
External Costs and Benefits

Example
By law Abercrombie cannot dump without
Fitch’s approval.
 Fitch and Abercrombie can negotiate
without cost.

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 21
MB MC
Costs and Benefits of
Eliminating Toxic Waste (Part 3)
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
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 22
MB MC
External Costs and Benefits

When polluters are liable:
Polluter’s income is lowered.
 Those injured by pollution will have higher
income.

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 23
MB MC
The Gain in Surplus from
Shared Living Arrangements
Will Ann and Betty Share an apartment?
Benefits of Shared Living
Total cost of
separate apartments
Total cost of
shared apartment
Rent savings
From sharing
(2)($400/month)
= $800/month
$600/month
$200/month
Costs of Shared Living
Problem
Ann’s phone usage
Ann’s cost of
solving problem
Curtailed
phone usage:
$250/mo.
Betty’s cost of
solving problem
Tolerate phone
usage: $150/mo.
Least costly
solution to
the problem
Betty tolerates
Ann’s phone usage:
$150/mo.
Gain in Surplus from Shared Living
Rent savings
($200/month)
Copyright c 2007 by The McGraw-Hill
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Least costly accommodation
to shared living problems
($150/month)
Chapter 12: Externalities and Property Rights
Gain in surplus
$50/month
Slide 24
MB MC
The Gain in Surplus from
Shared Living Arrangements
How much should Ann and Betty pay if they
agree to split their economic surplus equally?
Benefits of Shared Living
Total cost of
separate apartments
Total cost of
shared apartment
Rent savings
From sharing
(2)($400/month)
= $800/month
$600/month
$200/month
Costs of Shared Living
Problem
Ann’s phone usage
Ann’s cost of
solving problem
Curtailed
phone usage:
$250/mo.
Betty’s cost of
solving problem
Tolerate phone
usage: $150/mo.
Least costly
solution to
the problem
Betty tolerates
Ann’s phone usage:
$150/mo.
Gain in Surplus from Shared Living
Rent savings
($200/month)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Least costly accommodation
to shared living problems
($150/month)
Chapter 12: Externalities and Property Rights
Gain in surplus
$50/month
Slide 25
MB MC
External Costs and Benefits

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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 26
MB MC
External Costs and Benefits

Legal Remedies for Externalities

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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 27
MB MC
Legal Remedies for Externalities

Economic Naturalist

What is the purpose of speed limits and
traffic laws?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 28
MB MC
Legal Remedies for Externalities

Economic Naturalist

Why do most communities have zoning
laws?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 29
MB MC
Legal Remedies for Externalities

Economic Naturalist

Why do many governments enact laws that
limit the discharge of environmental
pollutants?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 30
MB MC
Legal Remedies for Externalities

Economic Naturalist

What is the purpose of free speech laws?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 31
MB MC
Legal Remedies for Externalities

Economic Naturalist

Why does government subsidize the
planting of trees on hillsides?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 32
MB MC
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)
Q
Quantity of
Pollution
Copyright c 2007 by The McGraw-Hill
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Chapter 12: Externalities and Property Rights
Slide 33
MB MC
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 = $1,000/ton
2,000
Private MC
1,300
D
8,000
Social
optimum
12,000
Private
equilibrium
Quantity (tons/year)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
D
8,000 12,000
Quantity (tons/year)
Chapter 12: Externalities and Property Rights
Slide 34
MB MC
Subsidizing a Positive Externality
Private equilibrium
without subsidy
Private equilibrium
with subsidy
Social
optimum
Price ($/ton)
XB = 6
Subsidy = 6
14
MC
10
8
14
MC
10
Social demand =
8
Private demand + XB
Subsidized demand =
Private demand + tax
Private
demand
Private
demand
1,200 1,600
Quantity (tons/year)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
1,200 1,600
Quantity (tons/year)
Chapter 12: Externalities and Property Rights
Slide 35
MB MC

Property Rights and the
Tragedy of Commons
The Problem of Unpriced Resources
When no one owns property, the
opportunity cost of using it is not
considered.
 Use of the property will increase until
MB = 0.

Copyright c 2007 by The McGraw-Hill
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Chapter 12: Externalities and Property Rights
Slide 36
MB MC
The Relationship Between
Herd Size and Steer Price
Number of steers
on the commons
Price per 2-year-old steer
($)
Income per steer
($/year)
1
126
26
2
119
19
3
116
16
4
113
13
5
111
11
A village has:
• 5 residents
• Each has savings = $100
• Each villager can buy a bond paying 13%/yr or a steer and
sell it in a year
• Investment decisions are individual and public
Will there be a socially optimal outcome?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Act individually to
maximize income
Individual choice
• 4 steers
= $52
• 1 bonds
= $13
• Total Income = $65
Slide 37
Marginal Income and the
Socially Optimal Herd Size
MB MC
Number of steers
on the commons
Price per
2-year-old steer
($)
Income
per steer
($/year)
Total cattle
Income
($/year)
Marginal
Income
($/year)
1
126
26
26
26
2
119
19
38
12
3
116
16
48
10
4
113
13
52
4
5
111
11
55
3
Act individually to
maximize income
Individual choice
• 4 steers
= $52
• 1 bonds
= $13
• Total Income = $65
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Act collectively to
maximize village income
Socially optimal choice
• 1 steer
= $26
• 4 bonds
= $52
• Total Income = $78
Chapter 12: Externalities and Property Rights
Slide 38
MB MC

Property Rights and the
Tragedy of Commons
The Problem of Unpriced Resources
When no one owns the commons, the
opportunity cost of using it is not
considered.
 Use of the commons 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.

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 39
MB MC

Property Rights and the
Tragedy of Commons
The Effect of Private Ownership

Example
 How
much will the right to control the village
commons sell for?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 40
MB MC

Property Rights and the
Tragedy of Commons
The Effect of Private Ownership

Assume
 Villagers
can borrow and lend at 13%.
 The villagers decide to auction off the rights to
the commons.
 One steer is the optimal number
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 41
MB MC

Property Rights and the
Tragedy of Commons
The Effect of Private Ownership

Assume
 Income
from one steer = $26.
 Pay $100 for the commons
o The $26 profit covers the cost of the loan to buy the
steer at the opportunity cost of $100 or $13
 Economic
surplus of the village will be:
o (4 x $13) + $26 = $78 or
o (4 x $13) + $13 rent + $13 highest bidder = $78
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 42
MB MC

Property Rights and the
Tragedy of Commons
The Effect of Private Ownership

Observations
 When
the land is auctioned, the highest bidder
will have an incentive to consider the
opportunity cost of grazing additional steers.
 Common property is not used efficiently.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 43
MB MC

Property Rights and the
Tragedy of Commons
The Effect of Private Ownership

Observations
 Zoning
laws and other regulations restrict the
use of private property.
 The laws can be used to maximize economic
surplus.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 44
MB MC

Property Rights and the
Tragedy of Commons
The Effect of Private Ownership

Observations
 The
laws can also be used to achieve an
individual goal (reelection) by reducing the
economic surplus.
 Private ownership may be impractical.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 45
MB MC

Property Rights and the
Tragedy of Commons
Economic Naturalist
Why do blackberries in public parks get
picked too soon?
 Why are shared milkshakes consumed too
quickly?

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 46
MB MC

Property Rights and the
Tragedy of Commons
When Private Ownership is Impractical
Harvesting timber on remote public land
 Harvesting whales in international waters
 Controlling multinational environmental
pollution

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 47
MB MC
Positional Externalities

Payoffs That Depend 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.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 48
MB MC
Positional Externalities

Payoffs That Depend on Relative
Performance

In a competitive situation:
 When
the payoff depends on relative
performance, incentive to invest in performance
activities will be excessive from a collective
point of view.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 49
MB MC
Positional Externalities

Economic Naturalist

Why do football players take anabolic
steroids?
 Smith
and Jones are competing for a single
position and a $1 million contract.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 50
MB MC
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.
Copyright c 2007 by The McGraw-Hill
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Chapter 12: Externalities and Property Rights
Slide 51
MB MC

Positional Arms Races and Positional
Arms Control Agreements
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
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Chapter 12: Externalities and Property Rights
Slide 52
MB MC

Positional Arms Races and Positional
Arms Control Agreements
Positional Arms Race

A series of mutually offsetting investments
in performance enhancement that is
stimulated by a positional externality
Copyright c 2007 by The McGraw-Hill
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Chapter 12: Externalities and Property Rights
Slide 53
MB MC

Positional Arms Races and Positional
Arms Control Agreements
Positional Arms Control Agreements

An agreement in which contestants attempt
to limit mutually offsetting investments in
performance enhancements
Copyright c 2007 by The McGraw-Hill
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Chapter 12: Externalities and Property Rights
Slide 54
MB MC

Positional Arms Races and Positional
Arms Control Agreements
Positional Arms Control Agreements
Campaign spending limits
 Roster limits
 Arbitration agreements
 Mandatory starting dates for kindergarten

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 55
MB MC

Positional Arms Races and Positional
Arms Control Agreements
Social Norms as Positional Arms
Control Agreements
Nerd norms
 Fashion norms
 Norms of taste
 Norms against vanity

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 12: Externalities and Property Rights
Slide 56
End of
Chapter
MB
MC