Economics 2023-02

1. Economics 2023-02 Class 20

2. Aplia • Last week, 81% of you did the Chapter 10 assignment, 75% the Chapter 11 assignment • Both did not generate high scores, the Chapter 10 lower than the Chapter 11. • Next Monday, April 2, the Chapter 12 Aplia assignments are due. It includes a news item analysis that is quite thought provoking and very good for understanding different kinds of goods. • No graded Aplia assignment on Chapter 13, but there is a practice problem set on chapter 13 that may help people with that material; it is available now, and will be available until 11.45 p.m. on Wednesday 3 April.

3. Some Definitions • Practice test questions – questions of the hardest type [most analytic] that will be on the next test • Practice test questions PDF only – i.e. a printable set of practice questions • Practice test questions in BB – i.e. as practice test in BB, immediate feedback on each • Mock test untimed – i.e. practice questions, but no feedback until complete • Mock test timed – practice questions, no feedback until deadline for doing it [probably Tuesday 11.45 p.m.] • Discussion on discussion board in BB encouraged

4. Survey: I prefer • Practice test questions PDF only – i.e. a printable set of practice questions • Practice test questions in BB – i.e. as practice test in BB, immediate feedback on each • Mock test untimed – i.e. practice questions, but no feedback until complete • Mock test timed – practice questions, no feedback until deadline for doing it [probably Tuesday 11.45 p.m.]

5. Today’s class • We begin talking about externalities, the Coase theorem and property rights, and how we can deal with the problems raised by externalities. • Competitive markets can produce efficient outcomes for ‘pure private goods’ when there are no externalities. • Pure private goods are goods that combine the characteristics of ‘rival in consumption’ and ‘excludability.’ • Externalities are present when someone other than those directly involved in the economic transaction or activity is affected by the transaction or activity.

6. Rival in consumption • A good or service is rival in consumption if when one buyer consumes a unit of it, no other buyer can consume that unit. • E.g., a haircut, a hamburger, or a shirt is rival in consumption. • On the other hand, this lecture, a showing of a movie with empty seats, a broadcast or a web page, or a plane or bus trip with empty seats is not rival in consumption – the fact that you consume it does not prevent others from consuming it. • Goods for which consumption is non-rival can be said to display MC = 0 over the relevant range.

7. Excludability in consumption • A good or service exhibits excludability if it is feasible to deny it to specific potential consumers. • Everything mentioned on the previous slide exhibits excludability. • However, some things don’t. E.g., street lighting, driving on downtown streets, defense from nuclear attack, elimination of malaria and yellow fever in Florida. • If you can’t exclude people, you can’t charge them directly so you can’t use the market to produce the optimal outcome.

8. A good is excludable when people who don't pay can be prevented from using it. • A good is rival when one person's consumption of the good reduces the amount available for others.

9. Examples: • Cable television is a natural monopoly -- cable providers can exclude non-paying customers (although cable theft is not unusual), but when one person watches a show there isn't any less of the show available for others. • A congested downtown road is a common resource -- anyone can drive on the road without paying, but adding another driver increases congestion and slows the trip for other drivers. • Area defense is a public good -- even tax evaders or transients get protection if Leon county attacked! • An apple is a private good -- sellers exclude those who don't pay, if I eat one, you can’t eat it.

10. Problem areas for markets • We will return to the issues of non-rival consumption and non-excludability at the end of the semester [chapter 16]; for today we are going to focus on the problems for markets raised by the existence of externalities.

11. 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.

12. Which of the following is an example of an activity with an external cost? • Raising honeybees where neighbors on all sides grow apples • Keeping the front yard clean • Reading a book • Speeding on the Interstate • Attending class

13. Example 21.1. 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.

14. If Sara plays only in response to her own costs and benefits, will the amount of time she plays be socially optimal? For Tom, Sara's music is a positive externality.

15. 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.

16. If follows that Sara plays too little.

17. Example 21.2. 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. If Sara plays only in response to her own costs and benefits, will the amount of time she plays be socially optimal?

18. For Harry, Sara's music is a negative externality. 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 less than their combined marginal costs.

19. It follows that Sara plays too much.

20. Negative externalities => too much activity Positive externalities => too little activity Compared to the optimal [efficient] amount

21. 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.

22. External Costs and Benefits How Externalities Affect Resource Allocation When an activity generates a negative externality, the level of the activity will be greaterthan the socially optimal level. When an activity generates a positiveexternality, the level of the activity will be lessthan the socially optimal level. IF we rely solely on unaided competitive markets to determine resource allocation.

23. How External Costs Affect Resource Allocation : Example – Mining creating pollution Social MC = Private MC + XC 2,300 XC = $1,000/ton PrivateMC 2,000 Private MC 1,300 1,300 D D Deadweight loss caused by pollution = $2mil/yr 12,000 8,000 12,000 Social optimum Private equilibrium Production with external cost Production without external cost Price ($/ton) Price ($/ton) Quantity (tons/year) Quantity (tons/year)

24. A Good Whose Production Generates a Positive Externality for Consumers: Example – a bakery • Without external benefits QPVTis the social optimum XB • With external benefits the private D < social D and the private optimum is less than the social optimum MBPVT + XB MC MBSOC MBPVT Social demand = Private Demand + XB Private Demand Qpvt QSOC Deadweight loss from positive externality Price Quantity

25. An external benefit implies that private markets will provide ____ and an external cost implies that private markets will provide _____ of the good (relative to the social optimum). • too much; too much • too little; too much • too little; too little • the right amount; too much • too much; too little

26. Example 21.3. Smith can produce with or without a filter on his smokestack. Production without a filter results in greater smoke damage to Jones.

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

29. Total economic surplus goes up if Smith installs the filter: $200-$35=$165 > $245-$85=$160.

30. 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 be willing to pay Smith to install the filter.

31. Ronald Coase: 1991 Nobel Laureate in Economics

32. The Coase Theorem: If (1) property rights are fully assigned and if (2) people can negotiate costlessly with one another, they will always arrive at efficient solutions to problems caused by externalities. Note these are two very heroic assumptions in terms of how the real world is.

33. Property Rights • By ‘property rights’ we mean what form(s) ownership can take, and what rights that confers on the owner. • We will concentrate on the simplest and, in the US, most familiar form of property right, where ownership typically confers complete rights to use, alter, sell, rent, damage or improve, or dispose of the owned thing, unless constrained by law. • However, note that this is not the only possibility. Property rights can take many forms; e.g. in many parts of the world, only usufructury rights to land are recognized, meaning one can use for given purposes but not sell, rent, or otherwise dispose of.

34. Traditional (pre-Coase) view: Smith is the perpetrator, 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? Who has the ‘right’ to the atmosphere? Who pays may depend on how we define the property rights.

35. Coase's insight was that externalities are completely 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.

36. When the pie grows larger, everyone can have a larger slice.

37. Suppose coal mining produces a negative externality in the form of polluted streams. One can deduce that, compared to the socially optimal outcome, the unregulated • price of coal is too high. • quantity of coal produced is too small. • quantity of coal produced is too high. • supply curve lies to the left of the regulated supply curve. • demand curve lies above the regulated demand curve.

38. Vote: Want to watch an 8 minute clip of Erin Brokovich, a movie about negative environmental externalities? • Yes • No

40. Example 21.4. Ted and Bill can live together in a two-bedroom apartment for $500/mo…

41. …or each rent a one-bedroom apartment for $300/mo.

42. 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.

43. 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?

44. 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?

45. 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 is less than the $100/mo gain, they should live together.

46. Example 21.5. 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.

47. Example 21.6. 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.

48. Note the problems .. • Even with just Ted and Bill, we have a problem – of negotiation. What if Ted says he won’t pay more than $285 and Bill says he won’t pay more than $205 – they won’t be able to get to an agreement, though either $285/215 or $295/205 would leave them both better off than the alternative. • In most real world externality situations, it is not one person who is affected, it is many – often very many. This makes negotiation of an agreement difficult if not impractical.

49. 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, society often tries to use the law to impose the burden of adjustment on the party that can accomplish it at lowest cost.

50. 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.