Chapter 10
Externalities and Property Rights
McGraw-Hill/Irwin
©2009 The McGraw-Hill Companies, All Rights Reserved
Learning Objectives
1. Define negative and positive externalities and analyze
their effect on resource allocations
2. Discuss and explain the Coase Theorem
3. Explain how the effects of externalities can be
remedied
4. Discuss why the optimal amount of an externality is
almost never zero
5. Characterize the tragedy of the commons and show
how private ownership is a way of preventing it
6. Define positional externalities and their effects
 Show how they can be remedied
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External Costs and Benefits
 External cost is a cost of an activity that is paid by on
people other than those who pursue the activity
 Also called a negative externality
 External benefit is a benefit of an activity received by
a third party
 Also called a positive externality
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Externalities Affect Resource Allocation
 Externalities reduce economic efficiency
 Solutions to externalities may be efficient
 When efficient solutions to externalities are not
possible, government intervention or other collective
action may be used
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Honeybee Keeper – Scenario 1
 Phoebe harvests and sells honey from her bees
 Bees pollinate the apple orchards
 No payments made to Phoebe
 The bees provide a free service to the local farmers
 Phoebe is giving away a service
 Private costs are equal to private benefits
 Social costs are less than social benefits
When external benefits exist,
maximizing private profits produces less
than the social optimum
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Honeybee Keeper – Scenario 2
 Phoebe harvests and sells honey from her bees
 Neighboring school and nursing homes are bothered by
bee stings
 The bees are a nuisance to the neighbors
 Phoebe is not paying all the costs of her honeybees
 Private costs are equal to private benefits
 Social costs are greater than social benefits
When external costs exist,
maximizing private profits produces more
than the social optimum
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External Costs
External Cost
Private
MC
1.3
D
12,000
Quantity (tons/year)
Price ($000s / ton)
Price ($000s / ton)
No External Cost
Social MC
$1,000/ton
2.3
2.0
Private
MC
1.3
D
8,000
12,000
Quantity (tons/year)
Deadweight loss from
pollution = $2 M/yr
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Social
Optimum
Private
Equilibrium
10 - 7
Positive Externality for Consumers
Deadweight loss from
positive externality
XB
Price
MBPVT + XB
MC
MBSOC
MBPVT
Social
Demand
Private Demand
Private
Equilibrium
LO 10 - 1
QPVT
Quantity
QSOC
Social
Optimum
10 - 8
Effects of Externalities
With externalities,
private market outcomes
do not achieve
the largest possible economic surplus
Cash is left on the table
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Remedying Externalities
 With externalities, private market outcomes do not
achieve the largest possible economic surplus
 Cash is left on the table
 For example, with monopolies, output is lower than with
prefect competition
 Introduction of coupons and rebates expands the
market
 With externalities, actions to capture the surplus are
likely
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10 - 10
Abercrombie the Polluter – Scenario 1
 Abercrombie’s company dumps toxic waste in the river
 Fitch cannot fish the river
 No one else is harmed
 Abercrombie could install a filter to remove the harm to
Fitch
 Filter imposes costs on Abercrombie
 Filter benefits Fitch
 Parties do not communicate
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Abercrombie's Filter Options
With Filter
Without Filter
Abercrombie's Gains
$100 / day
$130 / day
Fitch's Gains
$100 / day
$50 / day
Total Gains
$200 / day
$180 / day
 Abercrombie does not install the filter
 Marginal cost of filter to Abercrombie is $30 per day
 The marginal benefit to Fitch is $50 per day
 There is a net welfare loss of $20 per day
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Abercrombie the Polluter – Scenario 2
 Communications changes the outcome
 Fitch pays Abercrombie between $30 and $50 per
day to use the filter
 Net gain in total surplus of $20 per day
With Filter
Without Filter
Abercrombie's Gains
$100 / day
$130 / day
Fitch's Gains
$100 / day
$50 / day
Total Gains
$200 / day
$180 / day
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The Coase Theorem
 If people can negotiate the right to perform activities
that cause externalities, they can always arrive at
efficient solutions to problems caused by externalities
 Negotiations must be costless
 Sometimes those harmed pay to stop pollution
 The case of Abercrombie and Fitch
 Sometimes polluter buys the right to pollute
 Abercrombie pays Fitch if the value of polluting is
greater than the harm to Fitch
 The adjustment to the externality is usually done by the
party with the lowest cost
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Abercrombie the Polluter – Scenario 3
 Abercrombie’s company produces toxic waste
 Laws prohibit dumping the waste in the river
UNLESS Fitch agrees
 New gains matrix
With Filter
Without Filter
Abercrombie's Gains
$100 / day
$150 / day
Fitch's Gains
$100 / day
$70 / day
Total Gains
$200 / day
$220 / day
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Abercrombie the Polluter – Scenario 3
 Abercrombie can pay Fitch up to $50 per day for the
right to pollute
 Fitch will accept any offer over $30 per day
 In this scenario, polluting is the right thing to do
With Filter
Without Filter
Abercrombie's Gains
$100 / day
$150 / day
Fitch's Gains
$100 / day
$70 / day
Total Gains
$200 / day
$220 / day
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Laws Can Change the Outcome
 Suppose the law makes polluters liable for the cost of
cleaning up their pollution
 Polluters get lower incomes
 Non-polluters get higher incomes
With Filter
Without Filter
Abercrombie's Gains
$100 / day
$150 / day
Fitch's Gains
$100 / day
$70 / day
Total Gains
$200 / day
$220 / day
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Shared Living
 Ann and Betty are evaluating housing options
 2-bedroom apartment for $600 per month OR
 2 1-bedroom apartments for $400 per month each
 If the costs were the same, Ann and Betty would be
indifferent between the two arrangements
 The externality here is Ann's telephone usage is high
 She would pay up to $250 per month to be able to
use the phone whenever she wants
 Betty would pay up to $150 per month to get better
phone access
 No second phone line is possible
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Benefits and Costs of Shared Living
 Live together if the benefits exceed the costs
Total Cost of Separate
Apartments
Total Cost of
Shared Apartment
Rent Savings
from Sharing
$800 per month
$600 per month
$200 per month
Problem
Ann's Cost of
Solving the
Problem
Betty's Cost of
Solving the
Problem
Least-Cost
Solution
Ann's phone
usage
Pay Ann $250 to
decrease usage
Pay Betty $150
to tolerate Ann
Ann pays Betty
$150 per
month
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Net Benefit of Shared Living
Rent Savings
Cost of Phone
Accommodation
Gain in Surplus
$200 per month
$150 per month
$50 per month
 Ann and Betty will live together
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Dividing the Rent
 Betty would spend $400 per month to live alone
 The cost of tolerating Ann's phone use is $150 per
month
 Betty will be willing to pay up to $250 = $400 - $150
to live with Ann
 Above $250, she will be better off living alone
 Ann is willing to pay up to $400 per month, the cost of
living alone
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Dividing the Surplus
 Betty's maximum rent is $250
 Ann's maximum rent is $400
 If they divide the surplus ($50) equally,
 Betty pays $225 = $250 – $25
 Ann pays $375 = $400 – 25
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Legal Remedies for Externalities
 If negotiation is costless, the party with the lowest cost
usually makes the adjustment
 Private solution is generally adequate
 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
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Examples of Legal Remedies for Externalities
 Noise regulations (cars, parties, honking horns)
 Most traffic and traffic-related laws
 Car emission standards and inspections
 Zoning laws
 Building height and footprint regulations (sunshine
laws)
 Air and water pollution laws
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Three Cases
Free Speech
 First Amendment recognizes
the value of open
communications
 Hard to identify speech that
has a net cost
 Some limitations
 Yelling "fire" in a crowded
theatre
 Promote the violent
overthrow of the
government
 Pornography
LO 10 - 4
Planting Trees
 Government subsidizes trees
on private property
 Decreases chances of
flooding and landslides
 Net reduction of CO2 in the
atmosphere
Basic Research
 Millions of dollars spent by
federal government yearly
 Externalities of new
knowledge
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Optimal Amount of Negative Externalities
MC & MB
MC
Optimal amount
of pollution
MC = MB
MB
Q
Quantity of Pollution
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Taxing a Negative Externality
Pollution Tax
$1,000 / ton
Social MC
2.3
2.0
XC
Private
MC
1.3
D
Quantity (tons/year)
LO 10 - 4
Private MC + Tax
Tax
2.0
Private MC
1.3
D
8,000 12,000
8,000 12,000
Social
Optimum
Price ($000s / ton)
Price ($000s / ton)
No Pollution Tax
Private
Equilibrium
Quantity (tons/year)
After Tax
Equilibrium
Before Tax
Equilibrium
10 - 27
Subsidizing a Positive Externality
Subsidy
14
MC
XB
10
8
Social
Demand
Price ($ / ton)
Price ($ / ton)
No Subsidy
Subsidy
14
10
8
Subsidized
Demand
Private
Demand
Private
Demand
12 16
Quantity
(000s tons/year)
LO 10 - 4
MC
12 16
Quantity
(000s tons/year)
10 - 28
Tragedy of Commons
 When use of a communally owned resource has no
price, the costs of using it are not considered
 Use of the property will increase until MB = 0
 Suppose 5 villagers own land suitable for grazing
 Each can spend $100 for either a steer or a
government bond that pays 13%
 Villagers make sequential decisions
 They know what everyone before them has done
 Steers graze on the commons
 Value of the steer in year 2 depends on herd size
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Payoff For a Steer
 Using the information in the table below, each villager
makes a decision
# Steers
Selling Price per Steer
Income per Steer
1
126
26
2
119
19
3
116
16
4
113
13
5
111
11
 The fourth is indifferent between the two assets
 He buys a steer
 The fifth buys a bond
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What the Villagers Did
 The village has 4 steers feeding on the commons for
one year
 At the end of the year, 4 steers sell for $113 each
 Total revenue for the village is (5) (113) = $565
 Outcome is the same as 5 bonds
 They could have done better
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A Better Choice
# Steers
Selling
Price
Income per Total Cattle
steer
Income
Marginal
Income
1
126
26
26
26
2
119
19
38
12
3
116
16
48
10
 Net income from one bond after one year is $13
 Buy a steer only if its marginal benefit is at least $13
 First villager buys a steer and all others buy bonds
 Total net income is 26 + (4) (13) = $78
 A net gain of $13 compared to the first scenario
 Tragedy of the commons is the tendency for a resource that has
no price to be used until its marginal benefit is zero
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The Effect of Private Ownership
 The villagers decide to auction off the rights to the
commons
 Auction makes the highest bidder consider the
opportunity cost of grazing additional steers
 Villagers can borrow and lend at 13%.
 One steer is the optimal number
 Winning bidder pays $100 for the right to use the
commons
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The Effect of Private Ownership
 The winning bidder starts the year
 Spends $100 in savings to buy a yearling steer
 Borrows $100 at 13% to get control of commons
 The winning bidder ends the year
 Sells the steer for $126
 Gets original $100 back
 $13 opportunity cost of buying a steer
 $13 interest on loan for the commons
 Economic surplus of the village is
(4 x $13) + $26 = $78
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Property Rights and the Tragedy of Commons




Blackberries in the Park
Sweetness increases as the
berry ripens
Blackberries are common
property
 Berries will be eaten before
they are fully ripe
Other Examples
Harvesting
 Timber on remote public
land
 Whales in open oceans
Worldwide pollution controls
LO 10 - 5
Shared Milkshakes
 Milkshakes chill taste buds
 Decrease appreciation of
its flavor
 Drinking slowly increases
appreciation
 If two people share the
milkshake, it is a common
good
 They will drink faster than if
it were a private good
10 - 35
Positional Externalities
 Highest compensation goes to the best performer
 Standard is relative, not absolute
 Each player increases spending to increase probability
of winning
 Sum of all these investments > collective payoff
 Total payout is fixed, so players' group has no gains
LO 10 - 6
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Football Players Take Steroids
 Smith and Jones compete for one $1 million contract
 Each has 50% chance at the contract
 Smith and Jones have a Prisoner's Dilemma
Jones's Options
Smith's
Options
No Steroids
Steroids
LO 10 - 6
No Steroids
2nd
best for each
Best for Smith
Worst for Jones
Steroids
Worst for Smith
Best for Jones
3rd best for each
10 - 37
Positional Externalities
 Relative performance determines reward
 Positional externalities occur when an increase in
one person's performance reduces the expected
reward of another
 A positional arms race is a series of mutually
offsetting investments in performance enhancement
that is stimulated by a positional externalities
 A positional arms control agreement attempts to
limit the mutually offsetting investments in
performance enhancements by contestants
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Examples of Positional Arms Control Agreements
 Campaign spending limits
 Roster limits
 Arbitration agreements
 Mandatory starting dates for kindergarten
 Nerd norms
 Fashion norms
 Norms of taste
 Norms against vanity
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Externalities and Property Rights
Effects of
External
Costs
Tragedy of
the Commons
Externalities and
Property Rights
Effects of
External
Benefits
Remedies
Coase Theorem
Positional
Externalities
Laws
Taxes & Subsidies
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