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The Economic Way of Thinking 10eThe Economic Way of Thinking 10e ©Prentice Hall 2003©Prentice Hall 2003

““The Economic Way of Thinking”The Economic Way of Thinking”1010thth Edition Edition

by Paul Heyne, Peter Boettke, by Paul Heyne, Peter Boettke, and David Prychitkoand David Prychitko

“Externalities and Conflicting Rights”“Externalities and Conflicting Rights”

PowerPoint Slides prepared by PowerPoint Slides prepared by Assistant Professor Assistant Professor

Paul HarrisPaul HarrisCamden County CollegeCamden County College

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Chapter Outline

I.I. IntroductionIntroductionII.II. Externalities, Negative and PositiveExternalities, Negative and PositiveIII.III. Perfection is UnattainablePerfection is UnattainableIV.IV. NegotiationNegotiationV.V. Reducing Externalities Through Reducing Externalities Through

AdjudicationAdjudicationVI.VI. The Case of the Complaining The Case of the Complaining

HomeownerHomeowner

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VII.VII. The Importance of PrecedentsThe Importance of PrecedentsVIII.VIII. The Problem of Radical ChangeThe Problem of Radical ChangeIX.IX. Reducing Externalities Through Reducing Externalities Through

AdjudicationAdjudicationX.X. The Case of the Complaining HomeownerThe Case of the Complaining HomeownerXI.XI. The Importance of PrecedentsThe Importance of PrecedentsXII.XII. The Problem of Radical ChangeThe Problem of Radical ChangeXIII.XIII. Reducing Externalities Through Reducing Externalities Through

LegislationLegislation

Chapter Outline

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XIV.XIV. Minimizing CostsMinimizing CostsXV.XV. Another Approach: Taxing EmissionsAnother Approach: Taxing EmissionsXVI.XVI. Licenses to Pollute?Licenses to Pollute?XVII. Efficiency and FairnessEfficiency and FairnessXVIII.XVIII. The Bubble ConceptThe Bubble ConceptXIX.XIX. Rights and the Rights and the Social Social Problem of PollutionProblem of PollutionXX.XX. Traffic Congestion as an ExternalityTraffic Congestion as an ExternalityXXI.XXI. Once Over LightlyOnce Over Lightly

Chapter Outline

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Introduction

Decision MakingDecision MakingIndividuals weigh their courses of Individuals weigh their courses of

action by weighing the expected action by weighing the expected marginal benefits of any action by its marginal benefits of any action by its expected marginal cost. expected marginal cost.

Benefits and costs must matter to the Benefits and costs must matter to the actor to affect decisions.actor to affect decisions.

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Externalities,Negative and Positive

External Costs (spillover costs)External Costs (spillover costs) Negative externalitiesNegative externalities Costs not considered in decision Costs not considered in decision

makingmaking Congestion caused by slow drivers Congestion caused by slow drivers

creates extra travel time.creates extra travel time.

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External Benefits (spillover benefits)External Benefits (spillover benefits) Positive ExternalitiesPositive Externalities Benefits not considered in decision Benefits not considered in decision

makingmaking ExampleExample

House maintenanceHouse maintenance

Externalities,Negative and Positive

• QuestionQuestion– Does loud music create Does loud music create

a positive or a negative a positive or a negative externality?externality?

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• Negative externalities cannot be Negative externalities cannot be completely eliminated.completely eliminated.– Transaction costsTransaction costs

• Are the cost of arranging Are the cost of arranging contracts or transaction contracts or transaction agreements between suppliers agreements between suppliers and demanders.and demanders.

Perfection Is Unattainable

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Perfection Is Unattainable

• ScenarioScenario– Motorcycle rider leaves home early in Motorcycle rider leaves home early in

the morningthe morning– Imposes costs on neighborsImposes costs on neighbors

• QuestionQuestion– Why don’t they pay him to push his Why don’t they pay him to push his

cycle out of the neighborhood prior to cycle out of the neighborhood prior to starting it?starting it?

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• Internalizing ExternalitiesInternalizing Externalities– When individuals take into When individuals take into

account the external costs account the external costs (benefits) when making a (benefits) when making a decisiondecision

Perfection Is Unattainable

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Industrialize SocietiesIndustrialize SocietiesNegative externalities multiplyNegative externalities multiplyPeople ignore negative People ignore negative

externalitiesexternalitiesMust cultivate civic virtuesMust cultivate civic virtues

EmpathyEmpathyToleranceTolerance

Perfection Is Unattainable

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Negotiation

Negotiation is used to minimize social Negotiation is used to minimize social problems created by negative problems created by negative externalities.externalities.

Negotiation produces mutual gains from Negotiation produces mutual gains from exchange.exchange.

Failure to NegotiateFailure to Negotiate Creates high costs to othersCreates high costs to others

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� QuestionQuestion� Does negotiation occur if an isolationist moves Does negotiation occur if an isolationist moves

to a rural area?to a rural area?� Effective NegotiationEffective Negotiation

� Requires clearly defined property rights.Requires clearly defined property rights.� Clearly defined property rights provide the Clearly defined property rights provide the

basis for negotiationbasis for negotiation.

Negotiation

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Reducing ExternalitiesThrough Adjudication

AdjudicationAdjudicationA process for deciding who has which A process for deciding who has which rightsrightsClarifies property rightsClarifies property rights

QuestionQuestionWhat would happen if no one knew What would happen if no one knew what to do or what to expect from what to do or what to expect from others?others?

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The Case of theComplaining Homeowner

ScenarioScenarioPerson buys a housePerson buys a houseAirport is built nearby creating noiseAirport is built nearby creating noiseShould the owner be compensated for Should the owner be compensated for the costs created by the airplanes?the costs created by the airplanes?

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Pric

e pe

r pas

seng

er

Number ofpassengers

D

MC

Q1

P1

MCnoise tax

P2

Q2

The Case of theComplaining Homeowner

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QuestionsQuestionsWould compensating one require Would compensating one require compensating others?compensating others?Is this heavy cost on airlines and airports Is this heavy cost on airlines and airports justifiable?justifiable?If we correct this one, do we correct all If we correct this one, do we correct all negative externalities?negative externalities?

The Case of theComplaining Homeowner

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The Importance of Precedents

Compensation for Negative ExternalitiesCompensation for Negative ExternalitiesVirtually impossible to doVirtually impossible to doExpectations indicate property rightsExpectations indicate property rights

Court DecisionsCourt DecisionsThere is no error when the decision There is no error when the decision creates the rights.creates the rights.Error is possible when the decision Error is possible when the decision seeks to discover the rights.seeks to discover the rights.

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AdjudicationAdjudicationTries to avoid unexpected outcomesTries to avoid unexpected outcomesTries to support expectations that are Tries to support expectations that are widely and confidently heldwidely and confidently heldTries to maintain a continuity of Tries to maintain a continuity of expectationsexpectations

The Importance of Precedents

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The Problem of Radical Change

Technology sometimes forces rapid Technology sometimes forces rapid changes.changes.

New rules must be formed if negative New rules must be formed if negative externalities rapidly multiply.externalities rapidly multiply.

Rising incomes have created changes in Rising incomes have created changes in property rights.property rights.

Cost of pollution has changed.Cost of pollution has changed.

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We now place a high value on We now place a high value on clean air.clean air.Clean air as a rightClean air as a rightRequires new rulesRequires new rules

The Problem of Radical Change

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Reducing Externalities Through Legislation

• The creation of new rules is called The creation of new rules is called legislationlegislation..– Legislation creates changes in Legislation creates changes in

prevailing property rights. prevailing property rights. – Changing the rules of the game always Changing the rules of the game always

raises the question of fairness and raises the question of fairness and compels major changes in behavior.compels major changes in behavior.

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Reducing Externalities Through Legislation

• The creation of new rules is called The creation of new rules is called legislationlegislation..– Legislation creates changes in Legislation creates changes in

prevailing property rights. prevailing property rights. – Changing the rules of the game always Changing the rules of the game always

raises the question of fairness and raises the question of fairness and compels major changes in behavior.compels major changes in behavior.

The challenge for The challenge for a societya society

is to legislate in ways thatis to legislate in ways thatavoid gross injustice andavoid gross injustice andthat minimize the cost that minimize the cost

of achievingof achievingthe objectives. the objectives.

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Reducing Externalities Through Legislation

Each contributor to negative Each contributor to negative externalities acts as if his or her own externalities acts as if his or her own benefit exceeds in value the tiny benefit exceeds in value the tiny additional cost that this act imposes on additional cost that this act imposes on everyone in the community.everyone in the community.The solution to this problem is to The solution to this problem is to internalize those externalities through internalize those externalities through legislation.legislation.

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Minimizing Cost

• Minimizing cost isn’t the only Minimizing cost isn’t the only consideration when government consideration when government officials are trying to achieve officials are trying to achieve some objective.some objective.

• Fairness is also an criterion for Fairness is also an criterion for the evaluation of government the evaluation of government decisions. decisions.

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It is difficult at times for government It is difficult at times for government agencies to determine unit cost.agencies to determine unit cost.Polluters have an incentive to Polluters have an incentive to exaggerate their costs.exaggerate their costs.To resolve this kind information scarcity To resolve this kind information scarcity in the least costly manner, the EPA in the least costly manner, the EPA could impose tax per unit of emissions.could impose tax per unit of emissions.

Another Approach: Taxing Emissions

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Pollution is a Pollution is a spillover costspillover cost, a cost not borne by , a cost not borne by its producer.its producer.

If the per unit cost of pollutant is set equal to If the per unit cost of pollutant is set equal to the spillover cost per unit then the creator of the spillover cost per unit then the creator of the costs is made to bear them.the costs is made to bear them.

With the tax, less pollution will occur.With the tax, less pollution will occur. Question.Question.

At what point would pollution cease? At what point would pollution cease?

Another Approach: Taxing Emissions

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Another Approach: Taxing Emissions

The task of the EPA is The task of the EPA is to compare the to compare the

marginal cost of marginal cost of reducing the emissions reducing the emissions

with the marginal with the marginal benefits.benefits.

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Licenses to Pollute?

Most pollution should be Most pollution should be viewed as a cost, not a crime. viewed as a cost, not a crime.

By taxing the polluters the By taxing the polluters the government is providing in government is providing in effect, a effect, a “license to pollute”.“license to pollute”.

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Efficiency and Fairness

Some people object to taxes on Some people object to taxes on pollutants because they regard such pollutants because they regard such taxes as unfair.taxes as unfair.

They supposedly place the whole burden of They supposedly place the whole burden of the tax on the poor, while allowing the rich the tax on the poor, while allowing the rich to go on fouling the environment.to go on fouling the environment.

It must be shown that the efficient It must be shown that the efficient solution can be achieved while settling solution can be achieved while settling the fairness issue in different ways.the fairness issue in different ways.

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Efficiency and Fairness

The tax approach to The tax approach to pollutionpollution

reduction is in general reduction is in general superior to an approach superior to an approach

that assigns physicalthat assigns physical restrictions to restrictions to

particular firms.particular firms.

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The Bubble Concept

The bubble effect pretends that there is a giant The bubble effect pretends that there is a giant “bubble”“bubble” over the whole firm and control total over the whole firm and control total emissions into the bubble.emissions into the bubble.Under this policy firms could lower the cost of Under this policy firms could lower the cost of achieving a target level of air quality by achieving a target level of air quality by allowing emissions to rise wherever their allowing emissions to rise wherever their control was especially costly, and making it up control was especially costly, and making it up where emissions could be reduced at lower where emissions could be reduced at lower cost.cost.

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Rights and The Social Problem of Pollution

Pollution is a major social and political Pollution is a major social and political concern at this time because people disagree concern at this time because people disagree about rights.about rights.Demand is never completely inelastic for Demand is never completely inelastic for

any good, not even clean air.any good, not even clean air.Command and control should be avoided, Command and control should be avoided,

and people should be allowed the freedom and people should be allowed the freedom to choose the means of pollution reduction to choose the means of pollution reduction which lowers the cost to themselves.which lowers the cost to themselves.

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Traffic Congestion As An Externality

Traffic congestion is a negative externality.Traffic congestion is a negative externality.It is a cost generated by people who don’t It is a cost generated by people who don’t take it into account when making their take it into account when making their decisions. decisions. They only take into account the cost They only take into account the cost otherother drivers create.drivers create.If motorists had to pay the marginal If motorists had to pay the marginal congestion cost that their decision to drive congestion cost that their decision to drive imposed on others, as well as the cost to imposed on others, as well as the cost to themselves, they would choose to drive less. themselves, they would choose to drive less.

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Traffic Congestion As An Externality

QuestionQuestionHow can the externalities be How can the externalities be internalized?internalized?

AnswerAnswerPricing (congestion pricing)Pricing (congestion pricing)Pricing in the form of tolls for drivingPricing in the form of tolls for drivingGasoline cost pay the cost of Gasoline cost pay the cost of constructing the roads, not using constructing the roads, not using them.them.

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• Spillover cost are Spillover cost are actions that people actions that people take which impose take which impose costs on others that costs on others that the actors do not the actors do not take into account.take into account.– Economist refer to Economist refer to

these as spillover these as spillover cost, or externalities.cost, or externalities.

• Transaction cost Transaction cost frequently will frequently will prevent people from prevent people from negotiating more negotiating more satisfactory satisfactory arrangements.arrangements.– Negotiation is used to Negotiation is used to

secure cooperation.secure cooperation.– Clearly defined Clearly defined

property rights make property rights make negotiations easier. negotiations easier.

Once Over Lightly

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Once Over Lightly

Some pollutionSome pollution reductionreduction

activity is moreactivity is more efficient thanefficient than

others.others.

End of Chapter 13

Next, Chapter Next, Chapter 14 “Markets 14 “Markets

and and Government”Government”

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