Transcript Principles of Microeconomics

Externalities and Property Rights
Introductory Microeonomics
1
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.
2
Example 12.1.
 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.
 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?
3
Example 12.1.
 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.
4
Example 12.1.
 Thus, if Sara plays in response to her own costs and
benefits, Sara plays too little.
($/minute)
Marginal Cost
to Sarah
0.65
0.50
Marginal Benefit
to Sarah
T*
Minutes
MB to Tom
5
Example 12.2.
 Sara is an accomplished
classical violinist.
 Her neighbor Harry hates the
sound of violin music, and on
summer evenings becomes
distressed when Sara plays in
her garden.
 For Harry, Sara's music is a
negative externality.
 If Sara plays only in response
to her own costs and benefits,
will the amount of time she
plays be socially optimal?
6
Example 12.1.
 If Sara plays in response to her own costs and
benefits, she will continue to play until the marginal
benefit of playing another minute is equal to the
marginal cost.
 But since Harry also incurs costs from her playing, at
that point the marginal benefit of playing another
minute will be greater than their combined marginal
costs.
7
Example 12.2.
 Thus, if Sara plays in response to her own costs and
benefits, Sara plays too much.
Marginal Cost
to Sarah
($/minute)
0.75
0.50
Marginal Benefit
to Sarah
T*
Minutes
MC to Harry
8
Externalities and activity
 Negative externalities => too much activity
 Positive externalities => too little activity
9
Example 12.3.
 Smith can produce with or without a filter on his
smokestack.
 Production without a filter results in greater smoke
damage to Jones.
10
Example 12.3.
Gains to Smith
Damage to Jones
Smith produces Smith produces
with filter
without filter
$200/week
$245/week
$35/week
$85/week
If Smith is not liable for
smoke damages and if
the two parties can
negotiate costlessly with
one another, will he
install a filter?
11
Example 12.3.
Gains to Smith
Damage to Jones
Smith produces Smith produces
with filter
without filter
$200/week
$245/week
$35/week
$85/week
Total economic surplus goes up if Smith installs the filter:
$200-$35=$165 > $245-$85=$160.
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 pay Smith to install the filter.
12
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
Additional readings:
Posner, Richard A. (1993): “Nobel Laureate Ronald Coase and Methodology,”
Journal of Economic Perspectives, 7(4): 195-210.
“Of Bees and Lighthouses: Schools Brief,” The Economist, Feb 23, 1991, p.72.
13
Example 12.3.
 Traditional (pre-Coase) view:
 Smith is the perpetrator (the person who committed
a crime), 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?
14
Example 12.3.
 Coase’s 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.
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Benefit to all when the pie is larger
Smith
Smith
Jones
Jones
Surplus with
inefficient solution
Surplus with
efficient solution
16
Example 12.4.
Ted and Bill can live together in a two-bedroom apartment
for $500/mo…
17
Example 12.4.
…or each rent a one-bedroom apartment for $300/mo.
18
Example 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.
19
Example 12.4.
 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?
20
Example 12.4.
 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?
21
Example 12.4.
 If they live together
 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 ($80) is less than the $100/mo gain,
they should live together.
22
Example 12.5.
 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.
23
Example 12.6.
 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.
24
Costly negotiations
 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, the law tries to impose the burden of
adjustment on the party that can accomplish it at
lowest cost.
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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.
Quiet
Hospital Zone
26
Costly negotiations
In non-hospital zones, the law is more liberal in its
tolerance of noise.
In many cities, there are 11 PM noise curfews on
weekdays, midnight curfews on weekends.
For those who are interested in law and economics:
Bouckaert, Boudewijn and De Geest, Gerrit (eds.), Encyclopedia of
Law and Economics, Cheltenham, Edward Elgar, 2000
27
Example 12.7.
The Right to an Unobstructed View
 Lehman owns a house overlooking the lake, from
which he enjoys a commanding sunset view.
28
Example 12.7.
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.
Lehman
Martin
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Example 12.7.
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 the gain to Martin from 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 of the two houses would
Martin build?
Lehman
Martin
30
Example 12.7.
The Right to an Unobstructed View
 Value of view to Lehman: 100
 Value of second story to Martin: 280-200=80
 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.
 The efficient outcome is thus for Martin to build the
one-story house.
 And that is exactly what would happen if the two
parties could negotiate costlessly.
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Example 12.7.
The Right to an Unobstructed View
 Rather than see Martin build the taller house, it will be
in Lehman's interest to compensate Martin for
choosing the shorter version.
 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.
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Example 12.7.
The Right to an Unobstructed View
 Suppose, however, that negotiations between the two
parties were impractical.
 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.
 The optimal structure of property rights in this
particular example would be to prohibit any building
that blocks a neighbor's view.
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Example 12.7.
The Right to an Unobstructed View
 If the valuations assigned by the parties were
different, a different conclusion might follow.
 If, for example, 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 chose.
34
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.
35
Modified Coase Theorem
 In cities like San Francisco, strict zoning laws
prohibit construction that blocks an existing
building's line of sight
36
Modified Coase Theorem
 Zoning laws in cities where there is less to look at are
generally much more liberal in the kinds of buildings
they permit.
37
Modified Coase Theorem
 But even in cities that
have no special view
to protect at all,
zoning laws generally
limit the fraction of the
lot that can be
occupied by manmade
structures.
38
Example 12.8. Taxing Negative Externalities
 Two firms, X and Y, have access to five different production
processes, each one of which has a different cost and gives off a
different amount of pollution.
Process
(daily smoke)
A
(4 tons)
B
(3 tons)
C
(2 tons)
D
(12 tons)
E
(0 ton)
Cost to Firm X
200
290
700
1300
2100
Cost to Firm Y
50
80
140
230
325
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.
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Example 12.8. Taxing Negative Externalities
 The city council wants to cut smoke emissions by half.
To accomplish this, they are considering two options.
A. Require each firm to curtail its emissions by half.
B. 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 compare under
the two alternatives?
40
Example 12.8. Taxing Negative Externalities
A: If each firm is required to cut pollution by half, each
must switch from process A to process C.
The result will be two tons/day of pollution for each firm.
Process
(daily smoke)
A
(4 tons)
B
(3 tons)
C
(2 tons)
D
(1 tons)
E
(0 ton)
Cost to Firm X
200
290
700
1300
2100
Cost to Firm Y
50
80
140
230
325
The cost of the switch for firm X will be
700/day-200/day=500/day.
The cost to Y will be 140/day-50/day=90/day,
So total cost for the two firms = 590/day.
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Example 12.8. Taxing Negative Externalities
B: How will each firm respond to a tax of T per ton of
pollution?
Switching to the next process will cut pollution by 1 ton
per day and save tax of T/day.
If cost of switching to the next process is less than or
equal to T, it will switch, otherwise not.
42
Example 12.8. Taxing Negative Externalities
 T= 50/ton: Firm X would stick with process A. Firm Y
will switch to process B.
Process
(daily smoke)
A
(4 tons)
B
(3 tons)
C
(2 tons)
D
(1 tons)
E
(0 ton)
Cost to Firm X
200
290
700
1300
2100
Cost to Firm Y
50
80
140
230
325
A tax of 50/ton thus does not produce the desired 50
percent reduction in pollution.
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Example 12.8. Taxing Negative Externalities
 T= 91/ton. X will adopt process B, Y will adopt process
D.
Process
(daily smoke)
A
(4 tons)
B
(3 tons)
C
(2 tons)
D
(1 tons)
E
(0 ton)
Cost to Firm X
200
290
700
1300
2100
Cost to Firm Y
50
80
140
230
325
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.
Total cost for both firms is thus only 270/day, or 320/day
less than the cost of having each firm cut pollution by half.
44
Example 12.8. Taxing Negative Externalities
 Note that the taxes paid by the firm are not included in
our reckoning of the social costs of the tax alternative,
because this money is not lost to society.
 It can be used to reduce whatever taxes would
otherwise have to be levied on citizens.
45
Example 12.9. Pollution Permits
 Similar to the preceding example but now the
government issues pollution permits to the two firms,
allowing them to generate 4 tons of smoke daily, in
total.
 Will the pollution generated by the two firms change
with the different allocation of permits?
46
Example 12.9. Pollution Permits
 Similar to the preceding but now the government issues pollution
permits to the two firms, allowing them to generate 4 tons of
smoke daily, in total.
 Suppose each firm is given permits to generate 2 tons of smoke.
Process
(daily smoke)
A
B
(4 tons) (3 tons)
C
(2 tons)
D
(1 tons)
E
(0 ton)
Cost to Firm X
200
290
700
1300
2100
Cost to Firm Y
50
80
140
230
325
By moving from C to B, Firm X will generate 1 more ton of smoke but
will save a cost of $410. By moving from C to D, Firm Y will incur a
cost of $90. Negotiation will ensure the new allocation (3 tons for firm
X, and 1 ton for firm Y)
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The Tragedy of the Commons
48
Example 12.10
 A village has five residents, each of whom has
accumulated savings of $100.
 Each villager has two investment opportunities:
1. Buy government bond for $100 that pays 12%
interest per year.
2. Buy a year-old steer for $100, send it onto the
commons to graze, then sell it after one year.
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Example 12.10
 The Relationship Between Herd Size, Selling Price, and
Profit per Steer
Number of steers
on the commons
Price per 2-year- old
steer ($)
Profit per steer ($)
1
2
3
4
5
120
116
114
112
110
20
16
14
12
10
If each person decides individually how to invest, how
many steers will be sent onto the commons?
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Example 12.10
If each person decides individually how to invest, how many steers
will be sent onto the commons?




Number of steers on
the commons
Price per 2-year- old
steer ($)
Profit per steer ($)
1
120
20
2
116
16
3
114
14
4
112
12
5
110
10
Opportunity cost of investing in steer = 12
Send steer if and only if price of 2-year-old steer is at least 112
Four of the villagers send 1 steer, and hence a total of 4 steers.
Total village income = 12 + 4(12) = 60
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Example 12.10
In the preceding example, what is the socially optimal number of
steers?
Number of steers on
the commons
Price per 2-year- old
steer ($)
Value of herd ($)
1
120
120
2
116
232
3
114
342
4
112
448
5
110
550
 Decision rule for socially optimal investment:
Send another steer only if the value of the herd increases by at
least 12.
 Thus, we should send a second steer but not a third. Total income
= $32 + $36 = $68
52
Tragedy of commons
 The problem with private decisions is that no individual
has any incentive to take into account that an extra
steer will eat grass that otherwise would have been
available to the steers already on the commons.
 The tragedy of the commons is thus a type of
externality.
53
Example 12.11.
 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?
54
Example 12.11.
 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.
55
Examples of Tragedies of the Commons
Harvesting 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.
56
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.
57
Examples of Tragedies of the Commons
Harvesting 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.
58
Examples of Tragedies of the Commons
Pollution
Each individual polluter has
no incentive to take into
account the cost his pollution
imposes on others.
59
Tragedies of the Commons
 Clearly defined property rights are one way to solve the
tragedy of the commons
60
Example 12.12. (Chapter 1-4)
 Once a week, Smith purchases a six-pack of cola and
puts it in his refrigerator for his two children. He
invariably discovers that all six cans are gone on the
first day. Jones also purchases a six-pack of cola once
a week for his two children, but unlike Smith, he tells
them that each may drink no more than three cans. If
the children use cost-benefit analysis each time they
decide whether to drink a can of cola, explain why the
cola lasts much longer at Jone’s house than at Smith’s.
61
Example 12.12. (Chapter 1-4)
 At Smith’s house, each child knows that the cost of not
drinking a can of cola now is that it is likely to end up
being drunk by his sibling. Each thus has an incentive to
consume rapidly to prevent the other from encroaching
on his share.
 Jones, by contrast, has eliminated that incentive by
making sure that neither child can drink more than half
the cans. This step permits his children to consume at a
slower, more enjoyable pace.
62
Defined property rights as a solution to tragedy
of the commons
Weyerhauser doesn't cut trees down too quickly on its own land.
Weyerhaeuser is an international forest products company with annual sales of
$22.6 billion. It was founded in 1900 and currently employs about 54,000
people in 18 countries.
63
Defined property rights as a solution to tragedy
of the commons
People don't
harvest
blackberries too
soon from their
backyard
garden.
64
Defined property rights as a solution to tragedy
of the commons
People don't
dump toxic
wastes into their
own swimming
pools.
65
Regulation as a solution to tragedy of the
commons
Fishing licenses limit the amount of fish that can
be taken.
66
Regulation as a solution to tragedy of the
commons
Laws regulate air and water pollutants.
67
Regulation as a solution to tragedy of the
commons
Zoning laws limit the size and other features of
buildings, signs, land-use patterns, etc.
68
Regulation as a solution to tragedy of the
commons
Mandatory recycling
69
Example 12.13
 In the cattle-grazing economy considered earlier,
suppose there is now a 25% tax on income earned from
cattle.
 If people decide individually between bonds and cattle,
how many steers will be sent onto the commons?
70
Example 12.13
With a 25% tax on income from cattle, only 2 steers will be
sent onto the commons, and this is the socially optimal
number.
Number of steers
on the commons
Price per 2-year- old
steer ($)
After-Tax Profit per
steer ($), with 25%
tax on cattle income
1
120
15
2
116
12
3
114
10.50
4
112
9
5
110
7.50
Total income = 3(12)
+ 2(12)
(bonds)
(cattle)
+
8 = 68
(tax)
71
Tragedy of the commons
 One of the continuing sources of inefficiency in modern
economies involves the allocation of resources that no
single nation's property laws and regulations can
govern.
 Several species of whales have been hunted to near
extinction because international laws of property are
insufficient to restrain individual incentives to kill
whales.
 The Mediterranean Sea has long had serious
problems with pollution, because none of the many
nations that border it has an economic incentive to
consider the effects of its discharges on other
countries.
72
Example: Why do football players take anabolic
steroids?
 Smith and Jones are
competing for a single
position and a $1 million
contract.
73
Example: Why do football players take anabolic
steroids?
Jones
Don’t take
steroids
Smith
Take
steroids
Don’t take
steroids
Second best for each
Best for Jones
Worst for Smith
Take
steroids
Best for Smith
Worst for Jones
Third best for each
•Dominant strategy for each yields the third best outcome
•This prisoner’s dilemma outcome is the attraction of rules
banning performance enhancing drugs.
74
Positional Arms Races and Positional Arms
Control Agreements
 Positional Externality
 When an increase in one person’s performance
reduces the expected reward of another in situations
in which reward depends on relative performance
 Positional Arms Race
 A series of mutually offsetting investments in
performance enhancement that is stimulated by a
positional externality
75
Positional Arms Races and Positional Arms
Control Agreements
 Positional Arms Control Agreements
 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
76
Positional Arms Races and Positional Arms
Control Agreements
 Social Norms as Positional Arms Control Agreements
 Nerd norms
Good grades vs. all study too hard
 Fashion norms
Avant-garde status vs. excessive body mutilation
 Norms of taste
Catching attention vs. too much nudity
 Norms against vanity
Cosmetic/reconstructive surgery vs. Michael
Jackson
77
End
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