Externalities and Property Rights

1
Externalities and Property Rights
2
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.

3
External Costs and Benefits

• External Cost (negative externality)
• A cost of an activity that falls on people other
  than those who pursue the activity
• e.g. air pollution/ noise pollution
• External Benefit (positive externality)
• A benefit of an activity received by people other
  than those who pursue the activity
• e.g. immunizations/ developments in new
  technology

4
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.

5
e.g. 12.1 External Benefits

• 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.
• For Tom, Sara's music is a positive externality.

If Sara plays only in response to her own costs
and benefits, will the amount of time she plays
be socially optimal?
6
e.g. 12.1 External Benefits

• 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.

7
e.g. 12.1 A Good Whose Production Generates a
Positive Externality for Consumers

Toms MB
Q (minutes)
Sara plays too little from the social viewpoint.
8
e.g. 12.2 External Cost

• Tom left, Sara has a new neighbour.
• New neighbor Harry hates violin music, and summer
  evenings become distressed when Sara plays in her
  garden.
• For Harry, Sara's music is a negative
  externality.

If Sara plays only in response to her own costs
and benefits, will the amount of time she plays
be socially optimal?
9
e.g. 12.2 External Cost

• 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 smaller than their
  combined marginal costs.
• Note To Harry, violin sounds are noise
  pollution that kills his productivity. So, he
  regards it as an increase in production cost from
  the societys point of view instead of a drop in
  marginal benefit.

10
e.g. 12.2 A Good Whose Production Generates a
Negative Externality for Consumers

Social MC Saras MC Harrys MC
Q (minutes)
QSOC
Sara plays too much from the social viewpoint.
11
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.

12
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.

13
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.

14
e.g. 12.3

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

15
e.g. 12.3
If Smith is not liable for smoke damages and if
the two parties can negotiate costlessly with one
another, will he install a filter?
16
e.g. 12.3

• The filter costs 245-20045 for Smith to
  install.
• Total economic surplus (for society) goes up if
  Smith installs the filter
• 200-35165 245-85160.
• 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
• 85-3550 for Jones, he will pay Smith to
  install the filter.

17
The Coase Theorem
If property rights are fully assigned and if
people can negotiate costlessly with one another,
they will always arrive at efficient solutions to
problems caused by externalities.
Ronald Coase 1991 Nobel Laureate in Economics
18
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.

19
Example 12.3

• 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?

20
e.g. 12.3

• Coases insight was that externalities are purely
  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.

21
Benefit to all when the pie is larger
22
e.g. 12.4
Ted and Bill can live together in a two-bedroom
apartment for 500/mo
23
e.g. 12.4
or each rent a one-bedroom apartment for 300/mo.
24
e.g. 12.4
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.
25
e.g. 12.4

• Ted would pay up to 150 per month rather than to
  reschedule his playing to some other time.
• Bill would pay up to 80 per month not to have
  his sleep disturbed.
• Will they live together or separately?

26
e.g. 12.4

• The question is whether the benefits of joint
  living exceeds the costs.
• The benefit is the 100 per month reduction in
  rent.(2 individual apt rent 300X2 600 1
  shared apt rent 500)
• What is the least costly accommodation to the
  trumpet problem?

27
e.g. 12.4

• If they live together
• Cost to Ted of stopping playing 150/month(pay
  at least 150 for rescheduling practice)
• Cost to Bill of tolerating the noise
  80/month(value of good sleep)
• So the least costly solution is for Bill to put
  up with the noise (since 80
• Since this cost (80) is less than the gain (100
  reduction in rent), they should live together.

28
e.g. 12.4

• 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/month and suffer no trumpet noise. Since
the noise costs him 80/month (in terms of good
sleep), the most he would be willing to pay for
the shared apartment is 300 - 80 220.
29
e.g. 12.4

• How should Ted and Bill split the 500/month rent
  if they agree that each should benefit equally
  from living together?

Their total gain from living together is 100
(reduction in rent) - 80 20/month. If Ted
pays 290/month and Bill pays 210/month, each
will be 10/month better off than to live alone.
30
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.

31
Costly negotiations

• However, it is often impractical to negotiate
  solutions to the problems created by
  externalities due to Transaction Costs (costs
  incur in negotiating/ agreeing/ and implementing
  an agreement) .
• E.g. Hospital patients are unable to negotiate
  with passing motorists about not blowing their
  horns.
• In such cases, the law tries to impose the burden
  of adjustment on the party that can accomplish it
  at the lowest cost.

32
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.

33
Costly negotiations
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.
34
e.g. 12.5 The Right to an Unobstructed View

• Legal Remedies for Externalities
• e.g. Why do most communities have zoning laws?
• Lehman owns a house overlooking the lake, from
  which he enjoys a commanding sunset view.

35
e.g. 12.5 The Right to an Unobstructed View

• Now Martin purchases the property below Lehman's
  and is considering which of two houses to build
  
• a one-story house that would leave Lehman's view
  intact
• or a two-story design that would completely block
  Lehman's view.

36
e.g. 12.5 The Right to an Unobstructed View

• Suppose the gain to Lehman from an unobstructed
  view is 100,
• the gain to Martin from having a one-story house
  is 200, and a two-story house is 280.
• If the laws of property let people build houses
  of any height they chose, and if negotiation
  between property owners were costless, which
  house would Martin build?

37
e.g. 12.5 The Right to an Unobstructed View

• Value of view to Lehman 100
• Value of second story to Martin 280-20080
• The increase in Martin's gain from having the
  taller house is 80, which is 20 less than the
  cost to Lehman from the loss of his view.

38
e.g. 12.5 The Right to an Unobstructed View

• Since we assumed ZERO negotiation cost
• The most efficient outcome is thus for Martin to
  build the one-story house.
• WHY?
• Rather than seeing Martin to build the taller
  house, it will be in Lehman's interest to
  compensate Martin for choosing the shorter
  version.

39
e.g. 12.5 The Right to an Unobstructed View

• To do so, he will have to give Martin at least
  80.
• The most Lehman would be willing to pay is 100,
  since that is all the view is worth to him.
• For some payment P, where 80?P?100, Lehman will
  get to keep his view.

40
e.g. 12.6 The Right to an Unobstructed View

• Suppose, however, that negotiations between the
  two parties were impractical due to a huge
  negotiation cost.
• Martin would then go ahead with the two-story
  house, since that is the version he values most.
  
• By comparison with the one-story design, Martin
  would gain 80, but Lehman would lose 100.

41
e.g. 12.6 The Right to an Unobstructed View

• In this case, the best solution/ optimal
  structure of property rights would be to prohibit
  any building that blocks a neighbor's view.
• i.e. the court would comes in and take over the
  role of resource allocation.
• Since the legal system may have a lower cost in
  assigning property rights and resolving conflicts
  between private parties.

42
e.g. 12.6 The Right to an Unobstructed View

• Of course, in these examples, if the valuations
  assigned by parties were different, a different
  conclusion might follow.
• If Martin valued the two-story house at 300 and
  Lehman valued the view at only 80, the optimal
  structure of property rights would be to allow
  people to build to whatever height they choose.

43
Modified Coase Theorem

• The optimal structure of property rights is the
  one that places the burden of adjustment (either
  the loss of a view or the loss of a preferred
  building design) on the party that can accomplish
  it at the lowest cost.
• As a practical matter, the laws of property in
  many jurisdictions often embody precisely this
  principle.

44
Legal Remedies for Externalities

• As said above, legal remedies are often chosen in
  correcting externalities.
• The most common form would be the use of taxation
  in tackling negative externalities and the use
  subsidies in tackling positive externalities.
• In particular, the most efficient form of
  taxation/ subsidies would be to impose a per-unit
  tax/ subsidy that equals to the marginal value of
  the externality.

45
Per Unit Tax on Negative Externality
46
Per Unit Subsidy on Positive Externality
Private equilibrium with per unit subsidy
Social optimum
XB 6/ ton
Subsidy 6/ ton
14
MC
10
Subsidized demand Private demand per unit
subsidy
8
Private demand
1,200
1,600
47
e.g. 12.7 Taxing Negative Externalities

• Two firms, X and Y, have access to five different
  production processes, each one has a different
  cost and gives off a different amount of
  pollution.

If pollution is unregulated, and negotiation
between the firms and their victims is
impossible, each firm will use A, the least
costly of the five processes. Each will emit 4
tons of pollution per day, for a total pollution
of 8 tons/day.
48
e.g. 12.7 Taxing Negative Externalities

• The city council wants to cut smoke emissions by
  half. To accomplish this, they are considering
  two options.
• I. Require each firm to curtail its emissions by
  half.
• II. Set a tax of T on each ton of smoke emitted
  each day.
• How large would T have to be in order to curtail
  emissions by half?
• And how would the total costs to society be
  different under the two alternatives?

49
e.g. 12.7 Taxing Negative Externalities

• I If each firm is required to cut pollution by
  half, each must switch from process A to process
  C.
• It will result in two tons/day of pollution for
  each firm.

The cost of the switch for firm X will be
700/day-200/day500/day. The cost to Y will
be 140/day-50/day90/day, So increase in total
production cost for the two firms 590/day.
50
e.g. 12.7 Taxing Negative Externalities

• II How will each firm respond to a pollution tax
  of T/ ton of pollution?Switching to the next
  process will cut pollution by 1 ton per day and
  save tax of T/day.
• Thus, if cost of switching to the next process
  is less than or equal to T, it will switch,
  otherwise not.

51
e.g. 12.7 Taxing Negative Externalities

• T 50/ton Firm X would stick with process A.
  Firm Y will switch to process B.

A tax of 50/ton thus does not produce the desired
50 percent reduction in pollution.
52
e.g. 12.7 Taxing Negative Externalities

• T 91/ton. X will adopt process B, Y will adopt
  process D.

Total emissions will be the desired 4 tons/day.
Cost to firm X will be 290/day-200/day 90/day.
Cost to firm Y will be 230/day-50/day 180/day.
Increase in total production cost for both
firms is thus only 270/day, or 320/day less than
policy I.
53
e.g. 12.7 Taxing Negative Externalities

• Note that the taxes paid by the firm are not
  included in our reckoning of social costs,
  because this money is not lost to the society.
• The tax revenue can be used to reduce whatever
  taxes would otherwise have to be levied on
  citizens.
• Thus, policy II would be more effective than
  policy I from the social point of view.

54
Property Rights and the Tragedy of Commons

• The Problem of Unpriced Resources
• A common refers to a resource with NO clearly
  defined property rights
• Thus, any parties can be entitled to the use of
  it
• When no one owns the commons, the opportunity
  cost of using it is not considered by these
  individuals
• i.e. One persons use of the commons imposes an
  external cost on the others by making the
  property less valuable. Still, no one will pay
  attention to it.

55
Property Rights and the Tragedy of Commons

• The Problem of Unpriced Resources
• Thus, a common will be kept using until all its
  value (to the society) is being exploited.
• We can expect that no one will be willing to pay
  a positive price in acquiring these commons.
• e.g. Would you like to buy an orange tree that is
  located along the Nathan Road, Kowloon?

56
Property Rights and the Tragedy of Commons

• The Problem of Unpriced Resources
• The Tragedy of Commons is a classic theory in
  economics that describes the dissipation of value
  of a valuable resource under undefined property
  rights.
• Without clearly defined property rights in
  protecting resources, economic agents will NOT be
  restrained from their selfish behaviour.

57
e.g. 12.8 The Tragedy of the Commons
In the following example, we will show how
individuals steering (cow breeding) decision
will exploit the value of a commonly owned
pasture (land with grass). Then, we will see how
cooperation alleviate the value dissipation
problem on pastures.
58
e.g. 12.8 The Tragedy of the Commons

• A village has five residents, each of whom has
  accumulated savings of 100.
• Each villager has two investment opportunities
• Buy government bond for 100 that pays 12
  interest per year, totally risk free.
• Buy a year-old steer for 100, send it onto the
  commons to graze, then sell it after one year.

59
e.g. 12.8 The Tragedy of the Commons

• The Relationship Between Herd Size, Selling
  Price, and Profit per Steer

If each person decides individually how to
invest, how many steers will be sent onto the
commons?
60
e.g. 12.8 The Tragedy of the Commons
If each person decides individually how to
invest, how many steers will be sent onto the
commons? (reminder each person has 100 to
invest on either 100 bond OR a 100 steer)

• Opportunity cost of investing in one steer
  return on government bond 12
• Send steer if and only if price of 2-year-old
  steer is at least 112
• Four of the villagers send 1 steer, and hence a
  total of 4 steers.
• Total village income 12 bond 4 steers X
  (12) 60

61
e.g. 12.8 The Tragedy of the Commons
However, what is the socially optimal number of
steers?

• Decision rule for socially optimal
  investmentSend another steer only if the NET
  value of the herd increases by at least 12,
  otherwise invest in bond.
• Thus, we should send a second steer but not a
  third. Total village income 32 (by 2 steers)
  36 (by 3 bond) 68

62
e.g. 12.8 The Tragedy of the Commons

• If the 5 villagers act individually in investment
  decision (objective max individual income)
• 4 villagers will buy graze steers and 1 will buy
  bond
• Total village income 12 1 buy bond 4
  steers X (12) 60
• If the 5 villagers act cooperatively (objective
  max villages total income)
• Only 2 villagers will graze steers. The remaining
  3 will notice that to the village, the 3rd
  steers return is lower than bond return, so
  these 3 people will buy bond
• Total village income 32 (by 2 steers) 36
  (by 3 bond) 68

63
e.g. 12.8 The Tragedy of the Commons

• The problem with private decisions is that no
  individual has any incentive to take into account
  that an extra steer will eat grass (and thus
  reduce the return on 2-yr-steer price) that
  otherwise would have been available to the steers
  already on the commons.
• The tragedy of the commons is thus a type of
  externality.

64
e.g. 12.9 The Tragedy of the Commons

• Sam and Stan are identical twins with a craving
  for chocolate malted milkshakes, and have agreed
  to share one.

• If each has a straw and each knows that the other
  is self-interested, will the rate at which they
  consume the milkshake be optimal?
• Each knows that any part of the milkshake he
  doesn't drink will be drunk by the other.
• So each consumes at a faster rate than he would
  if he had half the shake all to himself.

65
Examples of Tragedies of the CommonsHarvesting
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.
66
Examples of Tragedies of the Commons Picking
blackberries in a public park
Each individual knows that the blackberries would
taste better if allowed to ripen for another
week. But each also knows that blackberries
not eaten today may not be there next week.
67
Examples of Tragedies of the CommonsHarvesting
whales in international waters
Each individual whaler knows that harvesting an
extra whale reduces the breeding population of
whales and hence 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.
68
Private Property Rights

• Clearly defined property rights are one way to
  solve the tragedy of the commons
• 3 essential features of private property rights
• 1. right to exclusive use
• 2. right to income
• 3. right to ownership transfer

69
Defined property rights as a solution to tragedy
of the commons
Weyerhauser, an international forest products
company, doesn't cut trees down too quickly on
its own land.
70
Defined property rights as a solution to tragedy
of the commons
People don't harvest blackberries too soon from
their backyard garden.
71
Regulation as a solution to tragedy of the commons
When private property rights is hard to implement
and enforce, regulations can be an alternative
solution to commons.
e.g. Fishing licenses limit the amount of fish
that can be taken
72
Regulation as a solution to tragedy of the commons
Laws regulate air and water pollutants.
73
Regulation as a solution to tragedy of the commons
Zoning laws limit the size and other features of
buildings, signs, land-use patterns, etc.
74
e.g. 12.10 taxation as solution to tragedy of
commons

• Last but not least, taxation is also a solution
  to commons.
• In the steer-grazing economy considered earlier,
  suppose there is now a 25 tax on income earned
  from steering.
• If people decide individually between bonds and
  cattle, how many steers will be sent onto the
  commons?

75
e.g. 12.10 taxation as solution to tragedy of
commons
With a 25 tax on income from steers, only 2
steers will be sent onto the commons, and this is
the socially optimal number.
Total income 3(12) 2(12) 8
68 (bonds) (steers) (tax)
76
Coming next

• Tragedy of Commons illustrate how the deficiency
  of property rights will generate value
  dissipation on valuable resources.
• Next, we will turn to look at Positional
  Externality in economics

77
Positional Externalities

• Positional Externality
• When an increase in one persons performance
  reduces the expected reward of another in
  situations in which reward depends on relative
  performance
• e.g. Champion in tennis competition/
• first position in exams

78
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.
• When the payoff depends on relative performance,
  incentive to invest in performance activities
  will be excessive from a collective point of view.

79
e.g. 12.11 Why do football players take anabolic
steroids?

• Smith and Jones are competing for a single
  position and a 1 million contract.

80
e.g. 12.11 Why do football players take anabolic
steroids?
Jones
Dont take steroids
Take steroids
Dont take steroids
Smith
Take steroids

• Dominant strategy for each yields the third best
  outcome
• This prisoners dilemma outcome is the attraction
  of rules banning performance-enhancing drugs.

81
Positional Arms Race and Positional Arms Control
Agreement

• Positional Arms Race
• A series of mutually offsetting investments in
  performance enhancement that is stimulated by a
  positional externality
• e.g. steroid-consumption scandals in
  Olympics/
• advertising/
• political campaign spending

82
Positional Arms Race and Positional Arms Control
Agreement

• Positional Arms Control Agreement
• An agreement in which contestants attempt to
  limit mutually offsetting investments in
  performance enhancements
• Campaign spending limits
• Roster limits
• Arbitration agreements
• Mandatory starting dates for kindergarten

83
End of Chapter