Chapter 11 Externalities and Property Rights

1
Chapter 11Externalities and Property Rights

• Additional Questions,
• Q. 2, 3, 4, 10

2
Externalities

• Negative Externality
• a cost of an activity falls on people other than
  those who pursue the activity.
• i.e., a person smokes near you, you breathe in
  second-hand smoke .
• Individuals who consider only their own costs and
  benefits will tend to engage too much in
  activities that generate negative externalities.
• Thus, the private equilibrium quantity is more
  than the social equilibrium quantity
• QPVT gt QSOC

3
Externalities

• Positive Externality
• a benefit of an activity received by people
  other than those who pursue the activity.
• i.e., a person take a flu shot, it reduces the
  chances of infection.
• Individuals who consider only their own costs and
  benefits will tend to engage too little in
  activities that generate positive externalities.
• Thus, the private equilibrium quantity is less
  than the social equilibrium quantity
• QPVT lt QSOC

4
Externalities

• Negative and positive externalities create
  deadweight loss.
• It results in a loss in economic efficiency.

5
Externalities

• Tax and subsidy is a way to increase economic
  efficiency resulting from externalities.
• They induce producers to take account of a
  relevant benefit and cost that they otherwise
  would have ignored.
• Thus, the private MB curve becomes the social MB
  curve and the private MC curve becomes the
  social MC curve.
• As a result, improving economic efficiency and
  reducing the deadweight loss

6
Chapter 11, Problem 2

• Phoebe keeps a bee farm next door to an apple
  orchard. She chooses her optimal number of
  beehives by selecting the honey output level at
  which her private marginal benefit from
  beekeeping equals her private marginal cost.
• a) Assume that Phoebes private marginal
  benefit and marginal cost curves from beekeeping
  are normally shaped. Draw a diagram of them.

7

• a) Assume that Phoebes private marginal benefit
  and marginal cost curves from beekeeping are
  normally shaped. Draw a diagram of them.

/hive
Private MC
Ppvt
Private MB
Qpvt
Number of beehives
No external cost and benefit is involved. The
equilibrium price and quantity is socially
optimal.
8

• Phoebes bees help to pollinate the blossoms in
  the apple orchard, increasing the fruit yield.
  Show the social marginal benefit from Phoebes
  beekeeping in your diagram.

/hive
DWL
Private MC
Ppvt XB
P Soc
Ppvt
Social MB Private MB XB
XB
Private MB
Qpvt
QSoc
Number of beehives
External benefit (positive externality) is
involved in this case. The private market is
producing too little.
9

• c) Phoebes bees are Africanized killer bees
  that aggressively sting anyone who steps into
  their flight path. Phoebe, fortunately, is
  naturally immune to the bees venom. Show the
  social marginal cost curve from Phoebes
  beekeeping in your diagram.

Social MC Private MC XC
/hive
Private MC
XC
Ppvt XC
P Soc
Ppvt
Private MB
Qpvt
QSoc
Number of beehives
External cost (negative externality) is involved
in this case. The private market is producing too
much.
10

• Indicate the socially optimal quantity of
  beehives on your diagram, Is it higher or lower
  than the privately optimal quantity? Explain.
• If we combine the positive and negative
  externality, the socially optimal number of
  beehives could be greater or less than the
  privately optimal number
• depending on the magnitude of the social marginal
  cost relative to the private marginal cost and
• depending on the magnitude of the social marginal
  benefit relative to the private marginal benefit.

11

• If the negative externality is negligible and
  the positive externality is large

Social MC
/hive
Private MC
Social MB
Private MB
Number of beehives
Q soc
Q pvt
The socially optimal number of beehives, Qsoc ,
exceeds the privately optimal number, Qpvt.
12

• If the negative externality is large and the
  positive externality is negligible

Social MC
/hive
Private MC
Social MB
Private MB
Number of beehives
Q soc
Q pvt
The socially optimal number of beehives, Qsoc ,
is smaller than the privately optimal number,
Qpvt.
13
Chapter 11, Problem 3

• Suppose the supply curve of boom box rentals in
  Golden Gate Park is given by P 5 0.1Q, where
  P is the daily rent per unit in dollars and Q is
  the volume of units rented in hundreds per day.
  The demand curve for boom boxes is 20 0.2Q. If
  each boom box imposes 3 per day in noise costs
  on others, by how much will the equilibrium
  number of boom boxes rented exceed the socially
  optimal number?

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• Negative Externality

P 8 0.1Q
/unit
P 5 0.1Q
20
XC
PSOC
Ppvt
8
P 20 0.2Q
5
Number of rentals
Q pvt
Q SOC
Market Equilibrium 5 0.1Q 20 0.2Q Q
pvt 50 P pvt 10

• Imposition of 3 noise cost (external cost)
• Social supply curve original supply curve 3
• Social supply curve 8 0.1Q
• 8 0.1Q 20 0.2Q
• Q pvt 40
• P pvt 12

• If the negative externality (noise) is
  internalized into the rental, the equilibrium
  rental is greater than the social equilibrium
  rental by 10 (50 40)

15
Chapter 11, Problem 4

• Refer to problem 3. How would the imposition of
  a tax of 3 per unit on each daily boom box
  rental affect efficiency in this market?
• Tax is a way to increase economic efficiency
  resulting from externalities.
• Tax forces the producers to take into account the
  costs impose on others.
• Tax has the effect of raising each producers MC
  curve by the same amount as the external cost
  therefore, Private MC shifts up and equals to the
  Social MC.
• Thus, the resulting private equilibrium quantity
  equals to the socially optimal quantity.

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• The government can use taxes as an incentive for
  producers to cut back on externalities, i.e.
  pollution.
• Taxes used in this way are called Pigou taxes.
• By setting the tax rate equal to the marginal
  external cost, firms can be made to behave in the
  same way as they would if they bore the cost of
  externality directly.
• Thus, the imposition of a 3 per unit tax is
  efficiency-enhancing
• It actually internalizes the noise cost into the
  private supply curve
• After the imposition of tax, the supply curve
  becomes the social supply curve
• It helps bring the inefficient rental of boom
  boxes to the (socially) efficient rental of boom
  boxes

17
Additional Question

• Affordable housing is seen as a way to reduce
  crime rates and raise the quality of life of
  lower income neighborhoods.
• A) Given this information, what economic concept
  do you think is relevant to the analysis of the
  affordable housing market?

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• Affordable housing gives a positive externality
• It reduces the crime rates and raises the quality
  of life of other people in the neighborhood
• Therefore, the marginal social benefit of
  affordable housing is greater than the marginal
  private benefit for owners of affordable housing

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• B) Graphically show the market for affordable
  housing. What is the market equilibrium? What is
  the social optimum?
• C) Graphically show any deadweight loss in this
  market.

20

• As the marginal social benefit is greater than
  the marginal private benefit for affordable
  housing, the equilibrium quantity from a
  competitive market at Q1 is lower than the
  socially optimal quantity of Q2.

DWL
P2
P1
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• D) Discuss potential ways of reducing deadweight
  loss in this market.
• To reduce deadweight loss in this market, the
  government can subsidize the ownership of
  affordable housing by the same amount as the
  external benefit, so that the number of
  affordable homes increases toward Q2
• Subsidy is a way to increase economic efficiency
  resulting from externalities.
• It induces producers to take account of a
  relevant benefit that they otherwise would have
  ignored.
• Subsidy has the effect of raising each producers
  MB curve by the same amount as the external
  benefit therefore, Private MB shifts up and
  equals to the Social MB.
• Thus, the resulting private equilibrium quantity
  equals to the socially optimal quantity

22
Chapter 11, Problem 10

• A village has six residents, each of whom has
  accumulated savings of 100. Each villager can
  use this money either to buy a government bond
  that pays 15 percent interest per year or to buy
  a year-old llama, send it onto the commons to
  graze, and sell it after 1 year. The price the
  villager gets for the 2-year-old llama depends on
  the quality of the fleece it grows while grazing
  on the commons. That in turn depends on the
  animals access to grazing, which depends on the
  number of llamas sent to the commons, as shown in
  the following table

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• The villagers make their investment decisions one
  after another, and their decisions are public.
• If each villager decides individually how to
  invest, how many llama will be sent onto the
  commons, and what will be the resulting net
  village income?
• He will send llama onto the commons if the
  benefit is at least as large as the interest he
  could have earned on government bonds.

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• To buy a 100 government bond, 15 of interest
  will be earned, or 115 in total.
• Villager should send a llama on the commons if
  and only if that llama will command a price of at
  least 115.
• Therefore, 3 llamas will be sent onto the
  commons, 3 villagers will buy the government
  bond.
• Total village income 48 3(15) 93

Construct the table
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• What is the socially optimal number of llamas for
  this village? Why is that different from the
  actual number? What would net village income be
  if the socially optimal number of llamas were
  sent onto the commons?
• To maximize the income received by the group as a
  whole.
• We need to compare the marginal income.
• Recall, the amount that could be earned from a
  government bond is 15.
• Villagers should send llama onto the commons only
  if its marginal income is at least as large as
  15.

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The socially optimal number is to send 1 llama
onto the commons and buy 5 government bonds
instead of sending 3 llamas onto the commons and
buy 3 government bonds as in part a. This is
different from the actual number because in
deciding whether or not to send a llama, each
villager ignores the impact of his llamas
presence on the other llamas fleece quality.
The total village income would then be 22
5(15), 97. That amount is 4 more than the
total amount that resulted when villagers made
their investment decisions individually.
27

• The village committee votes to auction the right
  to graze llamas on the commons to the highest
  bidder. Assuming villagers can both borrow and
  lend at 15 percent annual interest, how much will
  the right sell for at auction? How will the new
  owner use the right, and what will be the
  resulting village income?
• If a single villager could control access to the
  commons, the most profitable way to use this land
  is to send only a single llama, and earn 22 per
  year.
• The opportunity cost of 100 spend on llama is
  the interest could have earned from buying
  government bond, 15.
• If the land were free, the owner would thus earn
  22 per year by raising one llama per year on it,
  or 7 more than she would have earned had she
  used her 100 to buy a bond.

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• The price of the land will be bid up until it
  owning the land is no better than putting the
  same amount in the bank at 15 percent interest.
• That price is the amount of money that would
  yield 7 per year if deposited at 15 percent
  interest, that is,
• 0.15x 7
• x 46.67
• Therefore, the new owner will graze one llama.
• The village income will be 97 22 5(15).

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Additional Question 1

• A cost or benefit that falls on people other
  than those pursuing an activity is called a(n)
•  
• positive externality.
• negative externality.
• externality.
• external cost.
• external benefit

Ans C
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Additional Question 2

• Which of the following is an example of a
  negative externality?
• Your neighbors enjoying the loud music you play.
• A firm dumping waste into a stream.
• Bees pollinating flowers on adjacent property.
• Whales swimming in international waters.
• None of the above.

Ans B
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Additional Question 3

• A negative externality will result in an
  equilibrium quantity of an activity that is
  _____________ the socially optimal quantity.
•  
• above
• below
• above or below
• equal to
• it can not be determined

Ans A
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Additional Question 4

• A positive externality will result in an
  equilibrium quantity of an activity that is
  _____________ the socially optimal quantity.
•  
• above
• below
• above or below
• equal to
• it can not be determined

Ans B
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Additional Question 5

• Which factor, if it were present, would lessen
  the ability of the Coase Theorem to solve an
  externality?
• The situation is already efficient.
• Negotiating requires hiring a lawyer.
• The parties are all self-interested.
• The potential gain in surplus is high.
• Property rights have already been assigned to one
  of the parties.

Ans B
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• Coase Theorem if at no cost people can negotiate
  the purchase and sale of the right to perform
  activities that cause externalities, they can
  always arrive at efficient solutions to the
  problems causes by externalities.
• Hiring a lawyer is a kind of transaction costs
  one has to spend time to find a lawyer, as well
  as paying the lawyer to do the negotiation. In
  other words, in order to exercise ones right,
  the person has to incur some transaction costs.
• Therefore, Option B is the answer.

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Additional Question 6

• Suppose there are ten people playing cards in a
  room. One of them wants to smoke a cigar nine
  of them dislike the smell of cigar smoke. The
  smoker values the privilege of smoking at 5, and
  each of the other nine occupants of the room
  would be willing to pay fifty cents for clean air
  in the room. The rules governing use of the room
  state that smoking is not allowed unless everyone
  agrees to allow smoking.

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• If the cigar smoker paid each other occupant
  0.50 for the right to smoke, the cigar smoker
  would be ? and the other occupants would be
  ? .
• Better off worse off.
• Better off just as well off as before the
  payment.
• Better off better off.
• Just as well off as before the payment better
  off.
• Worse off just as well off as before the
  payment.

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• According to the story
• The smokers reservation price for smoking is 5.
• Each of other occupants reservation price for
  clean air is 0.50.
• Now the smoker is paying to compensate the other
  occupants from the smoky air.

38

• There are 9 other occupants. Each of them is
  paid 0.50, which is their reservation price.
• Before the payment, they were enjoying clean air
  which was valued also at 0.50.
• Therefore, they are equally well off as before
  the payment.

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• The smokers reservation price for a drag is 5.
• He is paying 0.50 x 9 to smoke, which amounts to
  4.50.
• There is a 0.50 surplus.
• Hence, he is better off.
• Ans B

40
Additional Question 7

• The reason drivers would prefer building new
  roads to a 5 toll to reduce commute times is
  because
• Building roads is the only solution.
• They know a toll would not alter commuting
  behaviour.
• Cities always need new roads.
• The cost of new roads falls on all taxpayers the
  toll only falls on those who use the existing
  road.
• Of the commitment problem.
• Ans D

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• Options A and B are not right. We know that by
  setting a toll, the congestion on the highway can
  be reduced (and solved entirely).
• Option C does not make any economic sense at all.
• Option E is also not right, as we are not talking
  about competition or game theory.

42

• If a toll of 5 is imposed, users of the highway
  will have to pay money out from their pocket on a
  pay as you use basis.
• Which means the users will have to pay for what
  they use.
• This is not a problem until rational consumers
  realise that they can actually shift the
  financial burden to other people, spreading the
  contribution among all people in the city.

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• By having the government building more roads, all
  taxpayers in the cities are financing the
  project.
• Probably not all taxpayers are users of that
  highway anyway.
• Frequent highway users will find out that instead
  of paying 5 every single day, commuting on other
  peoples money (including theirs, but the cost is
  spread) is a bargain.
• And hence, Option D is the answer.

44
Additional Question 8

• Explain the following situations by using the
  concept Tragedy of the commons.
• Harvesting timber on public land
• Picking strawberries in a public park
• Harvesting whales in international oceans
• Environmental pollution

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• Tragedy of the commons the tendency for a
  resource that has no price to be used until its
  marginal benefit falls to zero.
• When no one has the private ownership to own any
  kind of property, i.e., land, ocean, swimming
  pool, he/she has no incentive to take the
  opportunity cost of using it into account.
• The cause of it is the fact that one persons use
  of commonly held property imposes an external
  cost on others by making the property less
  valuable.
• Solutions to the tragedy of commons are to place
  a clearly defined property ownership and to place
  a regulation of the use of property.

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• Harvesting timber on public land
• Each tree cutter knows that a tree not harvested
  this year will be bigger, and hence more valuable
  next year.
• But he also knows that if he doesn't cut the tree
  down this year, someone else will.
• Solution Laws regulated the amount of harvests
• b) Picking strawberries in a public park
• Each individual knows that the strawberries would
  taste better if allowed to ripen for another week
• But each also knows that strawberries not eaten
  today may not be there next week.
• Solution assign ownership on strawberries park

47

• Harvesting whales in international oceans
• Each individual whaler knows that harvesting an
  extra whale reduces the breeding population of
  whales
• Hence reduce the size of future whale
  populations, but he also knows that any whale he
  fails to harvest today will just be taken by some
  other whaler.
• Solution Fishing license
• d) Environmental pollution
• Each individual polluter has no incentive to take
  into account the cost his pollution imposes on
  others.
• Solution Tax

48
Additional Question 9

• People can purchase and sell the right to
  perform activities that cause externalities to
  arrive at efficient solutions. This describes
•  
• the Tragedy of the Commons.
• a positional externality.
• an external benefit.
• the Coase Theorem.
• the problem of unpriced resources.

Ans D