Topics Today 91108

1
Topics Today (9/11/08)

• Review of Classroom Game
• Public Goods
• Externalities
• Market Failure and Free Riding
• Example Air Pollution in Mexico City
• Homework 1 is on the website, due in class on
  Tuesday, 9/16.
• Read 2.4 in your textbook for next time.

2
Game 1 Externalities That Cause Public Bads

• Red cards are externalities.
• The externality is a direct result of the lack of
  well-defined property rights (i.e. the property
  rights are non-exclusive).

3
Property Rights

• A system of well-defined property rights has the
  following four characteristics
• Comprehensive all resources are owned, all
  entitlements defined.
• Exclusive all benefits and costs from use of a
  resource accrue to the owner.
• Transferable property right is transferable
  through voluntary exchange.
• Secure property right is secure from
  involuntary seizure by others.

See page 14 in your book
4
Game 1 Externalities That Cause Public Bads

• The score of the top teams was 57.
• The outcome of the game was inefficient. Why?
• All teams could have scored 180 if everyone had
  retained their red cards in each round.
• By reallocating resources we could make everyone
  better off and nobody worse off (i.e. we could
  improve efficiency).

5
Game 2 Public Goods

• Red cards are a public good.
• The public goods arise because of a lack of
  well-defined property rights (i.e. the property
  rights are non-exclusive).

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Game 2 Public Goods

• The score of the top teams in game 2 was 249.
• The outcome of game 2 was inefficient.
• If everyone had given up their red cards (i.e.
  contributed to the public good) then everyone
  would have scored 390.
• By reallocating resources we could make everyone
  better off and nobody worse off (i.e. we could
  improve efficiency).

7
Game 2 Your Teams Payoffs as a Function of
Other Teams Strategies
Regardless of the other teams strategy, your
team is always better off not contributing to
public goods provision.
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Game 2 Public Goods

• Q Wont people clean-up pollution or contribute
  to public goods for moral reasons?
• People contribute to public goods provision every
  day (e.g. charitable contributions).
• The question is not whether people contribute,
  but whether people contribute enough?
• In public goods provision there is always an
  economic incentive to free-ride.

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Free Riding

• Free riding enjoying a benefit without
  contributing to the provision of that benefit.
• Free riding is a direct result of non-exclusivity
  in property rights.
• In the classroom game, the highest scoring teams
  were free-riders.

10
Markets

• In a free market, all agents pursue what is in
  their best interest, without any restrictions.
• In a free market, it is (typically) not in the
  best interest of agents to limit production of
  negative externalities. Why not?
• First, it is costly and agents will not be
  adequately compensated for their costs.
• Second, agents have incentive to free-ride.

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Market Failure

• Market failure occurs when private means
  contradict the social ends of an efficient
  allocation of resources.
• Market failure occurs when the welfare theorem
  doesnt hold.
• If property rights are not well-defined, then
  market failure will occur.
• Externalities are a direct result of a lack of
  well-defined property rights.

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Market Failure

• Market failure often used as justification for
  government intervention.
• The government can intervene in the market by
  changing the underlying property rights (e.g.,
  take them away from the polluting firm)

13
Negative Externalities and Supply Curves

• Marginal private costs marginal costs that are
  borne directly by a firm producing a good.
• Marginal external costs the external cost
  imposed by the last unit of the good.
• Marginal social costs - all of the costs (private
  and external) associated with the production of
  the last unit of the good.

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Negative Externalities and Supply Curves
MCs Marginal Social Costs MCp Marginal Private
Costs
15
Competitive Equilibrium and Market Failure
Q Competitive Market Equilibrium Qs
Efficient (socially optimal) Amount of Q
16
Real-World Externalities

• The burning of the Cuyahoga River (OH)

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Real-World Externalities

• Urban Water Pollution

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Real-World Externalities

• Smog in Mexico City

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Market Failure

• The government can intervene in the market by
  changing the underlying property rights.
• A change in property rights gives rise to
  incentives.
• How to design incentives?

20
Mexico Citys Day Without A Car Policy

• Mexico City has been known to have some of the
  worlds worst air quality.

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Mexico Citys Day Without A Car Policy

• In 1989 the government introduced the Day
  Without A Car policy with the specific goal of
  reducing air pollution.
• Each person is not allowed to drive one day of
  the week.
• The last digit of the cars license plate
  determines which day residents are not allowed to
  drive (e.g. 1 means Mondays, 2 means Tuesdays,
  etc.).

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Mexico Citys Day Without A Car Policy

• Description of property right to the use of the
  environment.
• Before the policy residents had the right to
  drive as much as they like.
• After the policy residents had the right to
  drive as much as they like 6 days of the week,
  and no right to drive 1 day a week.

23
Mexico Citys Day Without A Car Policy

• Property rights give rise to incentives.
• How would people respond to this policy?
• Are people going to stay home from work?
• What will happen to public transportation?
• What about families that own two or more cars
  that have different license plates? Would such
  families just switch cars? Is it possible that
  such families could drive more than before the
  policy?
• What if one family member shuttled the other one
  around?
• What would happen to traffic before and after the
  restricted hours (i.e. nights and weekends)?

24
Mexico Citys Day Without A Car Policy

• Analysis by the World Bank showed that this
  policy increased air pollution.
• Many households bought additional cars.
• Multi-car households increased total driving due
  to shuttling.
• Weekend driving increased substantially.
• Changes in property rights may give rise to
  unintended incentives.

Eskeland, G.S., and T. Feyziouglu. 1995.
Rationing can backfire The day without a car in
Mexico City. World Bank Policy Research Paper
1554. (linked from course website).
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Mexico Citys Day Without A Car Policy

• Even if pollution were reduced, would the
  reduction be efficient?
• Ex/ Two residents, each makes 2 trips per day.
• Consumer surplus from the trips are valued at 1
  and 5.
• The loss in consumer surplus from the policy
  would be 6 per person to reduce 2 trips per
  person.
• If residents could choose any of the 2 trips to
  cut back during a week which ones would they
  choose?
• By reallocating, each resident would eliminate a
  1 trip on two different days.
• We could reduce the same number of trips at a
  loss of only 2 per person.

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Mexico Citys Day Without A Car Policy

• The property right is not transferable, therefore
  its not well-defined.
• Ex/ What if the two residents could trade?
• Assume the two have different days in which they
  cant drive.
• Each would be willing to pay up to 5 to be able
  to drive the high-value trip, and each would be
  willing to accept anything over 1 to give up
  their low-value trip.
• Trading between the two would reduce the same
  number of trips (2 trips / person) while making
  both better off more efficient.

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Mexico Citys Day Without A Car Policy

• World Bank study found that peoples driving
  habits were sensitive to price (e.g. a downward
  sloping demand curve).

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Mexico Citys Day Without A Car Policy

• Alternative policies
• Gas Tax
• Raise price of gas
• Incentives drive less and buy a more fuel
  efficient car.
• Tax credit for buying a hybrid car
• Reduce the price of fuel efficient car.
• Incentives buy a more fuel efficient car and
  drive more.
• Subsidize public transportation and carpooling
• Reduce the price of alternatives to driving.
• Incentives drive less.

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Mexico Citys Day Without A Car Policy

• Property rights to the use of the environment
• Gas Tax the government owns the property right,
  residents must pay for it.
• Tax credit for hybrids the residents own the
  property right, government must pay for it.
• Subsidize public transportation and carpooling
  the residents own the property right, government
  must pay for it.

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General Results

• Market failure calls for a change in the
  structure of property rights.
• The government solution may be worse than the
  problem, i.e., net benefit of government action
  can be negative.
• To be effective, the new structure must consider
  behavioral responses (what incentives are created
  for consumers and producers)?
• Policies that grant consumers and producers
  flexibility in achieving a social goal tend to be
  more efficient.