Understanding Economics Easily

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Economics and Society

ECON 10040

Dr. Christopher Jepsen, D212

Part 4 – Externalities and PropertyRights



Readings – Part 4

• McDowell et al. – Chapter 11



Equilibrium (Chapter 3)

• Supply = Demand

• Intersection of supplyand demand curves

• MB = MC

• Socially optimumoutcome

• No deadweight loss

Price

Quantity

D = MB

S = MC

Q*

P*



Example – Chickens

• Suppose your neighbor is a morning person

• He likes fresh eggs for his very early breakfast

•

He decides to raise chickens and sell the extraeggs



Chicken Example Continued

• What does your neighbour care about?

– Cost of raising chickens

• Suppose you are not a morning person

• Clucking wakes you up way too early!

• Chickens create negative externality for you



Negative Externality

• Book defines negative externality as “a cost of

an activity that falls on people other than

those who pursue the activity”

• Another textbook: “Externalities arise

whenever the actions of one party make

another party worse or better off, yet the first

party neither bares the costs nor receives thebenefits from doing so.”



Production vs. Consumption

• Production externality – external cost (benefit)created by producer

• Consumption externality – external cost

(benefit) is created by consumer• Which type is the chicken example?



Marginal Damage

• Marginal damage – additional cost above andbeyond the private cost of each additionalunit

• What would you be willing to pay to make theclucking stop?



Negative Production Externality

• PMB = Privatemarginal benefit

• SMB = Social marginal

benefit• PMC= Private marginal

cost

• SMC = Social marginal

cost• MD = marginal damage

• SMC = PMC + MD

Price

Quantity

D = SMB = PMB

PMC

Q pvt

P1

SMC

Q soc

P2

This triangle is the

deadweight loss

MD



Deadweight Loss (DWL)

• DWL occurs when1. Not having trades

where SMB >SMC

Or

2. Having tradeswhere SMC >SMB

Price

Quantity

D = SMB = PMB

PMC

Q pvt

Ppvt

SMC

Q soc

Psoc


deadweight loss

MD



Types of Externalities

• Negative production externality

• Negative consumption externality

•

Positive production externality• Positive consumption externality



Negative Consumption Externality

Price

Quantity

SMB

Q pvt

S = PMC = SMC

Q soc


deadweight loss

MD

D = PMB

Example: Smoking



Positive Consumption Externality

Price

Quantity

SMB

Q soc

S = PMC = SMC

Q pvt


deadweight loss

MB

D = PMB

Example: Landscaping



Positive Production Externality

Price

Quantity

D = SMB = PMB

SMC

Q soc

PMC

Q pvt


deadweight loss

MB

Example:

Beekeeper



Practice Exam Questions

1. What type ofexternality isshown?

2. What is thedeadweight loss?

3. What is socially

optimal Q?4. What Q will be

produced?

Price

Quantity

D = SMB = PMB

Q 1

SMC

Q 2

B

A

PMC

C



Solutions to Externalities

• Government and private options exist

• Examples:

– Government regulation banning chickens in urban

areas

– Neighbour giving you free eggs to compensate for

noise



Government Solution

• Regulation – nochickens inneighborhood

Price

Quantity

D = SMB = PMB

PMC

Q pvt

SMC

Q soc

DWL w/o regulation

MD

DWL with ban



More Government Solutions

• Another option is to impose penalties / fines

• Example – farmer pays penalties for every

chicken that clucks before 8am

• Will this work?

• How much should fine be?



Pigouvian Tax

• Tax = MD

• A tax movesproduction from

Q pvt to Q soc• But MD is hard to

measure

Price

Quantity

D = SMB = PMB

PMC

Q pvt

SMC

Q soc

MD



Government Solutions

• Government solutions also exist for positive

externalities



Positive Externality Solution (1)

Price

Quantity

SMB

Q soc

S = PMC = SMC

Q pvt

MB

D = PMB

• Give cash to everyone

who receives flu shot

• Cash = MB

• Quantity increases

from Q pvt to Q soc



Positive Externality Solution (2)

Price

Quantity

SMB

Q 2

S = PMC1

Q 1

MB

D = PMB

• Subsidize producers of

flu shots

• Subsidy = MB

• Quantity increases

from Q pvt to Q soc Subsidy

PMC2



Private Solutions

• Consider again ourchicken example

• Suppose

government doesnot intervene

Price

Quantity

D = SMB = PMB

PMC

Q pvt

SMC

Q soc

MD



Private Solutions Continued

• How could you and your neighbour work outprivate solution?

– What incentives could you provide?

• Without tax, neighbour has little incentive toreduce production



Private Solution – Pay (1)

• You could pay your neighbour not to raise

chickens

• Scenario #1:

– Neighbour’s benefit from chickens = €500

– Your cost from chickens = €800

• What should you do?



Private Solution – Pay (2)

• Scenario #2:

– Neighbour’s benefit from chickens = €1000

– Your cost from chickens = €800

• What should you do?



Coase Theorem

• Ronald Coase (University of Chicago) won

Nobel prize in 1991

• “If people can at no cost negotiate the

purchase and sale of the right to perform

activities that cause externalities, they can

always arrive at efficient solutions to problems

caused by these externalities.”



Efficiency

• Inefficient – can make one or more person

better off without harming anyone

• In scenario #1, paying your neighbour is

efficient

• In scenario #2, your neighbour paying you is

efficient



Property Rights

• The allocation of property rights is important

• Does your neighbour have the right to noisy

chickens?

• Do you have the right to peace and quiet?



Book Example – A & F

• Abercrombie owns textile factory by river

• Fitch is a fisherman on the river

•Abercrombie pollutes river – Installing a filter would eliminate pollution

With filter Without filter

Gains to Abercrombie €100 / day €130 / day

Gains to Fitch €100 / day €50 / day



#1 – A. Has Property Rights and

Transactions are Very Costly

• What is the equilibrium?

– No filter

–

Total output of €180 / day – Efficient?






#3a – Fitch Has Property Rights and

Transactions are Very Costly

• What is the outcome now?






#3b – Fitch Has Property Rights

• Assume transactions are costless

• What is the outcome?

–

Who pays whom? – How much?

– Efficient?






Optimal Amount of Externalities

• Supposeexternality ispollution

•

Efficient amount isQ soc

• Q = 0 is notefficient

Price

Quantity

D = SMB = PMB

PMC

Q pvt

Ppvt

SMC

Q soc

Psoc


deadweight loss

MD



Lack of Property Rights

• What happens when property rights for

valuable resources are not assigned?

– Fish in Atlantic ocean

– Wild animals in Africa

• Usually, resource is overexploited and wasted



Tragedy of the Commons

• “The tendency for a resource that has no price

to be used until its marginal benefit falls to

zero.”

• Without property rights, opportunity costs not

considered

• Example of externality



“Tragedy” Example – Irish Salmon

• Example 11.7: Atlantic salmon stocks

– EU Common Fisheries Policy

– Stocks depleted

– Why?



Tragedy of the Commons – Solutions?

• EU now has strict quotas on fishing

• Elephant poaching problem in Africa

– Ivory is valuable resource

– Some countries outlaw hunting

– Others privatise ownership



“Tragedy” Challenges

• What to do when private ownership is

impractical?

– Timber on remote public land

– Whales in international waters

– Multinational environmental pollution



Practice Exam Questions

Suppose Bill has property rights

1. What is equilibrium with transactions costs?

2. What is equilibrium w/o transaction costs?

Suppose John has property rights3. What is equilibrium with transactions costs?

4. What is equilibrium w/o transaction costs?

Dog externality example With dog Without dog

Gains to Bill €90 / day €130 / day

Gains to John €100 / day €70 / day

Understanding Economics Easily

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