Transcript ECON 1001 AB Introduction to Economics I Dr. Ka

Chapter 11
Externalities and Property
Rights
Q. 1, 5, 8, 9
Problem #1, Chapter 11
• Determine whether the following statements are true or false,
and briefly explain why
• A) A given total emission reduction in a polluting industry will
be achieved at the lowest possible total cost when the cost of
the last unit of pollution curbed is equal for each firm in the
industry
• B) In an attempt to lower their costs of production, firms
sometimes succeed merely in shifting costs to outsiders
Solution to Problem #1 (1)
• A) True
• Application of Equal Marginal Principle
• For optimal allocation of production, marginal cost should be
the same across all the firms
• If one firm’s marginal cost is higher than the other’s, it is costminimizing to divert the production from the firm with a
higher marginal cost to the firm with a lower marginal cost
Solution to Problem #1 (2)
• B) True
• Notion of Negative Externality
– It refers to situation where producers do not bear the complete
production cost and the leakage is borne by a three-party outside the
market
• Consider an example of production that generates sewage
– The sewage is supposed to be collected by a municipal government at
a per unit charge
– However, the manufacturer escapes from the discharge fee by
pumping the sewage into a river
– The river gets polluted and the society then bears an extra pollution
cost
Problem #5, Chapter 11
• Suppose the law says that Jones
may not emit smoke from his
factory unless he gets permission
from Smith, who lives downward.
If the relevant costs and benefits
of filtering the smoke from Jones'
production process are as shown
in the following table, and if
Jones and Smith can negotiate
with one another at no cost, will
Jones emit smoke?
Jones
emits
smoke
Jones
does not
emit
smoke
Surplus
for Jones
$200
$160
Surplus
for Smith
$400
$420
Solution to Problem #5 (1)
• The efficient outcome is for Jones to emit smoke
• Why?
• The total surplus for Jones to emit smoke ($600) is greater
than the total surplus for Jones not to emit smoke ($580)
• Jones gains more surplus by emitting smoke ($200 - $160 =
$40)
• Smith gains less surplus by authorizing Jones emit smoke
($420 - $400 = -$20)
• Note that Smith has the right to authorize Jones emit or not
emit smoke
Solution to Problem #5 (2)
• Since both Jones and Smith can negotiate with one another at
no cost, they can actually come up with a plan that is mutually
beneficial
• In order to induce Smith authorize Jones to emit smoke, Jones
can offer Smith a side payment $30 to Smith, so that Smith’s
lost in surplus (-$20) can be fully covered plus some extra gain
($10)
• Even if Jones has to pay Smith $30, Jones still gains $10 from
the deal
Problem #8, Chapter 11 (1)
• Barton and Statler are neighours in an apartment complex in
downtown Manhattan. Barton is a concert pianist, and Statler
is a poet working on an epic poem. Barton rehearses his
concert pieces on the baby grand piano in his front room,
which is directly above Statler’s study. The following matrix
shows the monthly payoffs to Barton and Statler when
Barton’s front room is and is not soundproofed. The
soundproofing will be effective only if it is installed in Barton’s
apartment.
Problem #8, Chapter 11 (2)
Soundproofed
Not
soundproofed
Gain to Barton
$100/month
$150/month
Gain to Statler
$120month
$80/month
Solution to Problem #8 (1)
• A) If Barton has the legal right to make any amount of noise
he wants and he and Statler can negotiate with one another
at no cost, will Barton install and maintain soundproofing?
Explain. Is his choice socially efficient?
• His choice is socially efficient
• Barton’s payoff without soundproofing is $50 greater than his
payoff with soundproofing
• Barton has the legal right to make noise
• He will of course not install the soundproof unless he receives
an additional income of at least $50
Solution to Problem #8 (2)
• Statler’s payoff without soundproofing is $40 less than his
payoff with soundproofing
• Statler’s additional payoff from having a soundproof is not
sufficient to feed Barton’s additional payoff from not having a
soundproof
• Both Barton and Statler will have no intention to negotiate
with one another
• Since the total payoff from not having a soundproof ($230) is
greater than the total payoff from having it ($220), it is
socially efficient
Solution to Problem #8 (3)
• We can notice that an inequitable allocation of payoff can be
socially efficient!
• B) If Statler has the legal right to peace and quiet and can
negotiate with Barton at no cost, will Barton install and
maintain soundproofing? Explain. Is his choice socially
efficient?
• As Statler’s payoff with soundproofing is $40 greater than his
payoff without soundproofing, he will exercise his right to
require Barton to install and maintain a soundproof
Solution to Problem #8 (4)
• The total payoff will then be $220, which is less than the total
payoff without soundproofing ($230)
• Statler’s choice is thus not socially efficient
• However, the negotiation cost is zero
• Barton will have an intention to negotiate with Statler on not
installing the soundproof by providing Statler a compensation
of $40 (Statler’s additional payoff from having a soundproof)
• Barton is willing to make this compensation, as he can gain an
additional payoff from not having a soundproof
• If such transaction occurs, the result will then be socially
efficient
Solution to Problem #8 (5)
• C) Does the attainment of an efficient outcome depend on
whether Barton has the legal right to make noise, or Statler
the legal right to peace and quiet?
• No, it is actually independent of who has the legal right on
either issues.
• Parts a and b arrive with the same result
• However, it is only true because the negotiation cost is zero in
this case
• If the negotiation cost is high enough to make transfer or
compensation infeasible, the attainment of an efficient
outcome will then become dependent on who has the legal
right on either issues
Problem #9, Chapter 11
• Refer to problem #8. Barton decides to buy a full-sized grand
piano. The new payoff matrix is shown in the matrix below
Soundproofed
Not
soundproofed
Gain to Barton
$100/month
$150/month
Gain to Statler
$120month
$60/month
Solution to Problem #9 (1)
• A) If Statler has the legal right to peace and quiet, and Barton
and Statler can negotiate at no cost, will Barton install and
maintain soundproofing? Explain. Is this outcome socially
efficient?
• Statler’s payoff with soundproofing is $60 greater than his
payoff without soundproofing
• He has the legal to peace and quiet
• Thus, Statler will exercise his right to require Barton to install
and maintain a soundproof
Solution to Problem #9 (2)
• Barton will not have an intention to negotiate with Statler, as
Barton’s additional payoff from not having a soundproof ($50)
is not enough to provide a compensation for Statler’s
additional payoff from having a soundproof ($60)
• Therefore, they will end up having a soundproof installed and
maintained
• It is an efficient outcome
• The total payoff from having a soundproof is $10 greater than
the total payoff from not having a soundproof
Solution to Problem #9 (3)
• B) Suppose that Barton has the legal right to make as much
noise as he likes and that negotiating an agreement with
Barton costs $15 per month. Will Barton install and maintain
soundproofing? Explain. Is this outcome socially efficient?
• Barton’s payoff without soundproofing is $50 greater than his
payoff with soundproofing
• Barton has the legal right to make noise
• He will of course not install the soundproof unless he receives
an additional income of at least $50
Solution to Problem #9 (4)
• On the other side, Statler’s payoff with soundproofing is $60
greater than his payoff without soundproofing
• However, Statler will have no intention to negotiate with
Barton, as there is a negotiation cost of $15
• In order to reach an agreement with Barton to install a
soundproof, Statler will need to pay a total of $65 ($50 + $15)it is beyond his additional payoff with soundproofing
• As the total payoff without soundproofing is $10 less than the
total payoff with soundproofing, the outcome is not socially
efficient
Solution to Problem #9 (5)
• C) Suppose Statler has the legal right to peace and quiet, and
it costs $15 per month for Statler and Barton to negotiate any
agreement. (Compensation for noise damage can be paid
without incurring negotiation cost.) Will Barton install and
maintain soundproof? Is this outcome socially efficient?
• As Statler’s payoff with soundproofing is $60 greater than his
payoff without soundproofing, he will exercise his right to
require Barton to install and maintain a soundproof
Solution to Problem #9 (6)
• The total payoff will then be $220, which is greater than the
total payoff without soundproofing ($210)
• Statler’s choice is thus socially efficient
• Barton will have no intention to negotiate with Statler on not
installing the soundproof by providing Statler a compensation
of $60 (Statler’s additional payoff from having a soundproof)
Solution to Problem #9 (7)
• D) Why does the attainment of a socially efficient outcome
now depend on whether Barton has the legal right to make
noise?
• It is attributed to the presence of negotiation cost
• The $15 negotiation cost blocks the efficient outcome, as total
amount Statler has to pay to compensate for Barton’s
additional payoff with soundproofing ($65) outweigh Statler’s
payoff with soundproofing ($60)
• However, if Statler has the legal right to peace and quiet
instead, no agreement is necessary to arrive at the efficient
outcome