Economics and Society ECON 10040Dr. Christopher Jepsen, D212 Part 4 – Externalities and Property Rights Readings – Part 4 • McDowell et al. – Chapter 11 Equilibrium (Chapter 3) • Supply = Demand Price • Intersection of supply and demand curves • MB = MC • Socially optimum outcome P* • No deadweight loss Q* S = MC D = MB Quantity 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 extra eggs 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 the benefits from doing so. Consumption • Production externality – external cost (benefit) created by producer • Consumption externality – external cost (benefit) is created by consumer • Which type is the chicken example? .Production vs. Marginal Damage • Marginal damage – additional cost above and beyond the private cost of each additional unit • What would you be willing to pay to make the clucking stop? . Negative Production Externality • PMB = Private marginal benefit Price • SMB = Social marginal benefit • PMC= Private marginal cost P2 • SMC = Social marginal P1 cost • MD = marginal damage • SMC = PMC + MD This triangle is the deadweight loss SMC MD PMC D = SMB = PMB Qsoc Qpvt Quantity . Not having trades where SMB > SMC Or 2. Having trades where SMC > SMB Price This triangle is the deadweight loss SMC MD Psoc Ppvt PMC D = SMB = PMB Qsoc Qpvt Quantity .Deadweight Loss (DWL) • DWL occurs when 1. Types of Externalities • • • • Negative production externality Negative consumption externality Positive production externality Positive consumption externality . Negative Consumption Externality Price This triangle is the deadweight loss Example: Smoking MD S = PMC = SMC D = PMB SMB Qsoc Qpvt Quantity . Positive Consumption Externality Price This triangle is the deadweight loss Example: Landscaping MB S = PMC = SMC SMB D = PMB Qpvt Qsoc Quantity . Positive Production Externality Example: Beekeeper Price This triangle is the deadweight loss PMC MB SMC D = SMB = PMB Qpvt Qsoc Quantity . What Q will be produced? Price B SMC PMC A D = SMB = PMB C Q2 Q1 Quantity . What type of externality is shown? 2. What is socially optimal Q? 4. What is the deadweight loss? 3.Practice Exam Questions 1. 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 – no chickens in neighborhood DWL with ban Price DWL w/o regulation SMC MD PMC D = SMB = PMB Qsoc Qpvt Quantity . 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 moves production from Qpvt to Qsoc • But MD is hard to measure Price SMC MD PMC D = SMB = PMB Qsoc Qpvt Quantity . Government Solutions • Government solutions also exist for positive externalities . Positive Externality Solution (1) Price S = PMC = SMC MB • Give cash to everyone who receives flu shot • Cash = MB • Quantity increases from Qpvt to Qsoc SMB D = PMB Qpvt Qsoc Quantity . Positive Externality Solution (2) Price S = PMC1 MB Subsidy PMC2 SMB D = PMB Q1 Q2 • Subsidize producers of flu shots • Subsidy = MB • Quantity increases from Qpvt to Qsoc Quantity . Private Solutions • Consider again our chicken example • Suppose government does not intervene Price SMC MD PMC D = SMB = PMB Qsoc Qpvt Quantity . Private Solutions Continued • How could you and your neighbour work out private solution? – What incentives could you provide? • Without tax. neighbour has little incentive to reduce 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.” . your neighbour paying you is efficient . paying your neighbour is efficient • In scenario #2.Efficiency • Inefficient – can make one or more person better off without harming anyone • In scenario #1. 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 Gains to Abercrombie Gains to Fitch With filter €100 / day €100 / day Without filter €130 / day €50 / day • Abercrombie owns textile factory by river • Fitch is a fisherman on the river • Abercrombie pollutes river – Installing a filter would eliminate pollution . #1 – A. Has Property Rights and Transactions are Very Costly Gains to Abercrombie Gains to Fitch With filter €100 / day €100 / day Without filter €130 / day €50 / day • What is the equilibrium? – No filter – Total output of €180 / day – Efficient? . Has Property Rights and Transactions are Costless Gains to Abercrombie Gains to Fitch With filter €100 / day €100 / day Without filter €130 / day €50 / day • What is equilibrium? – Fitch pays Abercrombie to install filter – How much? – Efficient? .#2 – A. #3a – Fitch Has Property Rights and Transactions are Very Costly Gains to Abercrombie Gains to Fitch With filter €100 / day €100 / day Without filter €130 / day €50 / day • What is the outcome now? . #3b – Fitch Has Property Rights Gains to Abercrombie Gains to Fitch With filter €100 / day €100 / day Without filter €150 / day €70 / day • Assume transactions are costless • What is the outcome? – Who pays whom? – How much? – Efficient? . Optimal Amount of Externalities • Suppose externality is pollution • Efficient amount is Qsoc • Q = 0 is not efficient Price This triangle is the deadweight loss SMC MD Psoc Ppvt PMC D = SMB = PMB Qsoc Qpvt Quantity . resource is overexploited and wasted .Lack of Property Rights • What happens when property rights for valuable resources are not assigned? – Fish in Atlantic ocean – Wild animals in Africa • Usually. 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 Dog externality example With dog Without dog Gains to Bill €90 / day €130 / day Gains to John €100 / day €70 / day Suppose Bill has property rights 1. What is equilibrium w/o transaction costs? Suppose John has property rights 3. What is equilibrium with transactions costs? 4. What is equilibrium with transactions costs? 2. What is equilibrium w/o transaction costs? .