EXTERNALITIES Externality When one persons actions imposes a cost or benefit on the well-being of a bystander. Externalities usually result in market failure. Externalities can be: Positive: 1) Positive: an external benefit is imposed on someone. (examples: gardens, restored historic buildings, research) Negative: 2) Negative: an external cost is imposed on someone. (examples: exhaust from autos, barking dogs, noise from airplanes) Externalities cause markets to allocate resources inefficiently. This happens through: 1) CONSUMPTION: consuming a good results in externality. 2) PRODUCTION: producing a good results in externality. In general, an external cost means the market overproduces the good (ie, paint). An external benefit means the market underproduces the good (ie, gardens) Are there benefits for other people in the parking lot when someone puts their car alarm on? ANSWER: Yes, because thieves dont know which cars have alarms. What about the club? What about the club? Are there benefits for other people in the parking lot when someone puts the club on their car? ANSWER: No...because the thief can SEE the club. Your neighbor puts in a nice garden. Are you receiving a benefit? When you admit you are receiving a positive benefit, your neighbor asks you to pay him $100 a month for the benefit. When you say no, he puts up a fence. What if you lived next door to this? Do you receive a benefit? The tendency for a society to overuse and therefore abuse common resources is called: TRAGEDY OF THE COMMONS What is a free-rider? Someone who uses the good but doesnt pay for it. Free riders occur when there are nonexclusion and shared consumption. Spraying for mosquitoes Police & fire protection National defense Street lights Even though water is essential for life and diamonds are not, water is cheap and diamonds are expensive? Why? It has to do with the elasticity of the supply curve and the amount of consumer/producer surplus Price Quantity Consumer Surplus Q S Price Quantity Producer Surplus S Q P P D D With DIAMONDS, supply is very inelastic. With WATER, supply is very elastic. Today, there are thousands of lawsuits over condos and owners rights or trees loosing leaves in your neighbors yard. If your cat is in your neighbors yard, is it your neighbors cat? What if your cat kills a bird in your neighbors yard? Externalities Positive (+benefit) Negative (+cost) Production (honey) Consumption (education) Consumption (cigarettes) Production (pollution) In review: Game Theory can be illustrated by what is called THE PRISONERS DILEMMA. The police have enough evidence to convict Bonnie and Clyde of possession of an illegal firearm so that each would spend 1 year in jail. But they suspect that the two have pulled off some bank robberies but they have no evidence. They put Bonnie and Clyde in separate rooms and offer a deal. Right now, we can lock you up for one year. But if you testify against your partner, we will set you free and your partner will get 20 years in prison. If you both confess to the crime, we can avoid the cost of a trial and you both get 8 years. Bonnies Decision confess Remain silent Clydes Decision 8 years each Bonnie - 20 yrs Clyde goes free Bonnie goes free Clyde - 20 yrs. 1 year each Each prisoner has two strategies, confess or remain silent. However, the sentence that each gets depends upon the actions of the other. OR you can use the PAYOFF MATRIX Bonnies Decison Clydes Decison confess Remain silent B: 8 years C: 8 years B: free C: 20 years B: 20 years C: free B: 1 year C: 1 year