Chapter 10: Externalities and Property Rights

1. Chapter 10: Externalities and Property Rights

2. Learning Objectives • Define negative and positive externalities and analyze their effect on resource allocations • Explain how the effects of externalities can be remedied • Compare and contrast the ways in which taxes and tradable permits can be used to reduce pollution • Discuss why the optimal amount of an externality is not zero • Characterize the tragedy of the commons and show how private ownership is a way of preventing it • Define positional externalities and their effects • Show how they can be remedied

3. External Costs and Benefits • External cost is a cost of an activity that is paid by 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 • Externality an external cost or benefit of an activity

4. Externalities • This chapter focuses on how externalities affect the allocation of resources • Adam Smith’s theory of invisible hand applies to an ideal market, in which externalities do not exist • In an ideal market, self-interested actions of individuals would lead to socially efficient outcomes • In the case of externalities, when the parties affected can easily negotiate with one another, the invisible hand will still produce an efficient outcome

5. 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

6. Honeybee Keeper – Scenario 1 • Asal harvests and sells honey from her bees • Her neighbors grow apples • Bees pollinate their apple orchards • The bees provide a free service to the local farmers • Asal is giving away a service • No payments made to Asal • If Asal takes only her own costs and benefits into account in deciding how many hives to keep, will she keep the socially optimal number of hives?

7. Honeybee Keeper – Scenario 1 • The bees provide a free service to the local farmers • Since the orchard owners also benefit from additional hives, the total benefit of adding another hive at that point will be greater than its cost • Private costs are equal to private benefits • Asal, then, will keep too few hives • Social costs are less than social benefits When external benefits exist, maximizing private profits produces less than the social optimum

8. Honeybee Keeper – Scenario 2 • Asal 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 • Asal 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 morethan the social optimum

9. How Do Externalities Affect Supply / Demand? External Cost No External Cost Social MC Private MC $1,000/ton 2.3 Price ($000s / ton) 2.0 1.3 Private MC Price ($000s / ton) 1.3 D D 12,000 Quantity (tons/year) 8,000 12,000 Quantity (tons/year) Deadweight loss from pollution = $2 M/yr Social Optimum Private Equilibrium

10. How Do Externalities Affect Supply / Demand? • Since the external pollution cost falls not on firm owners but on others who live downwind from their factories, • Private MC is still the supply curve for this product, and its demand curve is again as before, • So the equilibrium price and quantity will be exactly the same as the one represented by the left graph

11. How Do Externalities Affect Supply / Demand? • But this time the private market equilibrium is not socially optimal • As before, the market equilibrium level of output is 12,000 tons per year • However at that output level, the value to consumers of the last unit of output produced is only $1,300 per ton, while the true cost of producing that last unit (including the external cost) is $2,300 per ton

12. How Do Externalities Affect Supply / Demand? • This means that society could gain additional economic surplus by producing fewer units of the product • The same conclusion will continue to hold whenever the current output exceeds 8,000 (where demand curve intersects Social MC) • As output expands past 8,000, the marginal cost of each successive unit (as measured on the Social MC curve) is greater than the marginal benefit of that unit (as measured on the demand curve) • This entails a reduction in total economic surplus • Deadweight loss from pollution is $2 million

13. Positive Externality for Consumers Deadweight loss from positive externality XB MBPVT + XB MC Price MBSOC MBPVT Social Demand Private Demand QPVT QSOC Social Optimum Private Equilibrium Quantity

14. How Do Externalities Affect Supply / Demand? • To summarize, • Whether externalities are positive or negative distort the allocation of resources in efficient markets • When externalities are present, the individual pursuit of self-interest will not result in the largest possible economic surplus • The outcome is thus inefficient

15. Effects of Externalities • With externalities, private market outcomes do not achieve the largest possible economic surplus • Cash is left on the table

16. 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

17. The Coase Theorem • To say that a situation is inefficient means that it can be rearranged in a way that would make at least some people better off without harming others • The existence of inefficiency means that there is cash on the table, which usually triggers a race to see who can capture it • For example, because monopoly pricing results in an inefficiently low output level, the potential for gain gave monopolists an incentive to make discounts available to price-sensitive buyers

18. Fawaz the Polluter – Scenario 1 • Fawaz’s company dumps toxic waste in the river • Fawzi cannot fish the river • No one else is harmed • Fawaz could install a filter to remove the harm to Fawzi • Filter imposes costs on Fawaz • Filter benefits Fawzi • Parties do not communicate

19. Fawaz’s Filter Options • Fawaz does not install the filter • Marginal cost of filter to Fawaz is $30 per day • The marginal benefit to Fawzi is $50 per day • There is a net welfare loss of $20 per day

20. Fawaz the Polluter – Scenario 2 • Communications (at no cost) changes the outcome • Fawzi pays Fawaz between $30 and $50 per day to use the filter • Net gain in total surplus of $20 per day

21. 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 Fawaz and Fawzi • Sometimes polluter buys the right to pollute • Fawaz pays Fawzi if the value of polluting is greater than the harm to Fawzi • The adjustment to the externality is usually done by the party with the lowest cost

22. The Coase Theorem • 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 caused by externalities

23. Fawaz the Polluter – Scenario 3 • Fawaz’s company produces toxic waste • Laws prohibit dumping the waste in the river UNLESS Fawzi agrees • New gains matrix

24. Fawaz the Polluter – Scenario 3 • Fawaz can pay Fawzi up to $50 per day for the right to pollute • Fawzi will accept any offer over $30 per day • In this scenario, polluting is the right thing to do

25. Price Incentives and the Environment • Goods with negative externalities tend to be overproduced • Social objective is to reduce pollution by half from its unregulated level • The most efficient solution is one where the marginal cost of pollution abatement is the same for all polluters • Cost data are not available to government • One solution is to have all reduce pollution by the same proportion • Uneven distribution of costs

26. Price Incentives and the Environment • One policy option is to tax pollution • Businesses decide how much pollution to produce • 2 firms, 5 production processes each • Production differs by cost and amount of pollution Cost of Production and Amount of Smoke Emitted T = ton

27. Price Incentives and the Environment • If there are no regulations, each firm produces at its lowest cost, production method A • Each firm produces 4 tons of smoke per day • Government wants to cut pollution by half • Option 1: Set maximum pollution limits • Option 2: Tax smoke at a rate of $T per ton • Determine T to reduce pollution by half • Each option has costs to society that must be considered

28. Reducing Pollution by Regulation • Each firm moves to production process C • Costs increase $500/day for Sludge and $80/day for NW Lumber • Total cost to society of this plan is $580/day Cost of Production and Amount of Smoke Emitted

29. Taxing Pollution • If tax is $T per ton, the firms will reduce pollution as long as the cost of reductions is less than $T • A tax of $101 moves Sludge to B and NW Lumber to D • Total cost is $100 for Sludge + $180 for NW = $280/day • Net savings of $300/day over regulation Cost of Production and Amount of Smoke Emitted

30. Price Incentives and the Environment • Taxing pollution concentrates pollution reduction in firms that can accomplish it at the least cost • Cost – Benefit Principle • Cost of the last ton of smoke removed is the same for all firms • It can be difficult to determine the optimal tax rate • Set the tax too high and you get too little reduction • Set the tax too low and you get too much reduction • Marginal cost exceeds marginal benefit to society

31. Auctioning Pollution Permits • Set a target level for total pollution allowed • Auction 4 permits to allow 4 tons/day • Determine price of a permit, who buys them, and the total cost of pollution reductions Cost of Production and Amount of Smoke Emitted

32. Auctioning Pollution Permits Cost of Production and Amount of Smoke Emitted Benefit of Permits

33. Auctioning Pollution Permits • At a price of $90, 6 permits are demanded • 4 for Sludge and 2 for NW Lumber • At a price of $100, 5 permits are demanded • At a price of $101, 4 permits are demanded • Sludge uses process B and NW uses process D

34. Advantages of the Auction • Utilizes low cost pollution control • Permit fees can offset other taxes • Total cost same as with tax; administratively simple • Predictable operating and investing environment • Citizens can lobby government to set target pollution Cost of Production and Amount of Smoke Emitted

35. Shared Living • Deena and Leena are evaluating housing options • 2-bedroom apartment for $600 per month OR • 2 1-bedroom apartments for $400 per month each • If the rents were the same, Deena and Leena would be indifferent between the two arrangements • Except, Deena talks constantly on the phone • Deena would pay up to $250 per month to be able to use the phone whenever she wants • Leena would pay up to $150 per month to get better phone access • No second phone line is possible • Should they live together?

36. Benefits and Costs of Shared Living • Live together if the benefits exceed the costs

37. Net Benefit of Shared Living • Deena and Leena will live together 

38. Dividing the Rent • Leena would spend $400 per month to live alone • The cost of tolerating Deena's phone use is $150 per month • the highest monthly rent she would be willing to pay for the shared apartment is $400  $150 = $250 • Above $250, she will be better off living alone • Deena is willing to pay up to $400 per month, the cost of living alone • But the difference is $350 which is better than paying $400 to live alone

39. When Are Legal Remedies for Externalities Needed? • 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

40. When Are Legal Remedies for Externalities Needed? • A motorist with a noisy muffler imposes costs on others • Yet we cannot flag him down and offer him a compensation payment to fix his muffler • In recognition of this difficulty, most governments simply require that cars have working mufflers • A large share of laws is to solve problems caused by externalities • The goal of such laws is to help people achieve the solutions they might have reached had they been able to negotiate with one another

41. 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

42. Three Cases Free Speech • Free speech laws recognize 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 a government 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

43. Optimal Amount of Negative Externalities • As pollution is reduced • The marginal benefit from its reduction tends to fall • The marginal cost from its reduction tends to increase • As a result, the marginal cost and marginal benefit curves almost always intersect at less than the maximum amount of pollution reduction • The intersection of the two curves marks the socially optimal level of pollution reduction • This implies the existence of a socially optimal level of pollution, and that level will almost always be greater than zero

44. Optimal Amount of Negative Externalities MC & MB MC Optimal amount of pollution MC = MB MB Q Quantity of Pollution

45. Optimal Amount of Negative Externalities • But to speak of a socially optimal level of pollution is not the same as saying that pollution is good • It is to recognize that society has an interest in cleaning up the environment, but only up to a certain point • Think of your apartment • You can spend the whole day cleaning • Or you can tolerate some amount of dirt

46. Taxing a Negative Externality Pollution Tax$1,000 / ton No Pollution Tax Private MC + Tax Social MC 2.3 XC Tax 2.0 2.0 Price ($000s / ton) Price ($000s / ton) Private MC Private MC 1.3 1.3 D D 8,000 12,000 8,000 12,000 Quantity (tons/year) Quantity (tons/year) Social Optimum Private Equilibrium After Tax Equilibrium Before Tax Equilibrium

47. Taxing a Negative Externality • Critics insist that taxes always reduce economic efficiency • This tax actually makes the economy more efficient • The tax forces producers to take explicit account of the fact that each additional unit of output they produce imposes an external cost of $1,000 on the rest of society • Similar reasoning suggests that a subsidy to producers can serve to counteract misallocations that result from positive externalities

48. Subsidizing a Positive Externality No Subsidy Subsidy Subsidy MC MC XB 14 14 Price ($ / ton) Price ($ / ton) 10 10 Subsidized Demand Social Demand 8 8 Private Demand Private Demand 16 16 12 12 Quantity (000s tons/year) Quantity (000s tons/year)

49. Property Rights and the Tragedy of The Commons • People who grow up in industrialized nations tend to take the institution of private property for granted • Our intuitive sense is that people have the right to own any property they acquire by lawful means and to do with that property as they see fit • 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

50. The Tragedy of The Commons • Suppose 5 villagers own land suitable for grazing • Each can spend $100 for either a steer or invest in a risk-free market that pays 13% • Steers graze on the commons for 1 year before being sold in year 2 • Value of the steer in year 2 depends the weight it gained which depends on herd size • Villagers make sequential decisions