Externalities

&
Property Rights

Definitions
External cost
Cost incurred by a 3rd party
Negative effects on uninvolved parties

External benefit
Benefit received by 3rd party
Positive effects on uninvolved parties

Externality
Effect (+/-) on non-actors

Effect of Externalities:
Effect on uninvolved parties

Negative
Externality
Citizens breath bad
air and have to
clean their cars
more often.

Orchard owner
benefits from
bees to
pollinate trees.

Positive
Externality

Bee keeper
benefits from
orchard for
bees to collect
honey.

Examples
When I paint my house, my neighbors
house becomes more valuable
When I leave garbage in my yard, it
decreases the value of the neighboring
houses
When I speed, I make the road less safe
for others

Externalities (I)
External Cost
Raises Societys Cost above Private Cost
Private suppliers underestimate the true cost
Private market decides quantity by
Equating private cost to private benefit.

With underestimated cost

Private market supplies too much.
Private market under-prices the good or service

Dead Weight Loss

Benefit
lity
a
n
ter
x
E
Payment
ive
t
a
Cost
Ne g

Cons Surp = Bene - Payment

Prod Surp = Receipts Var Cost

t
s
o
lC
a
i
c
os t
So
C
at e
v
i
r
P

Society Desired P & Q

Effect of a Negative Externality

Private market would
choose
Q = 50
P = 50

With each unit causing a

$20 external cost
Increases cost to 70
Society would prefer
Q = 40
P = 60

Deadweight loss is
.5 x $20 x 10 units= $100
Area of triangle w/ corner
@ P = 60, edge Q=50
Due to excess units

Negative Externalities
(External Costs): Graphically
Demand and Supply measure benefit and
cost for the parties to the transaction
Private decisions lead to Q1

P
S

If other people are hurt, total cost is greater than

the private cost shown on the Supply curve (S)
This additional cost can be shown by
constructing a 2nd (total cost) Supply curve
With external costs, total cost
exceeds private cost

D
Q

Total cost calls for Q2

External costs lead to lost surplus due to overproduction

Dead weight loss: Society benefit minus society cost
between Q where society is best off and private profit maximum Q.

Externalities (II)
External Benefit
Raises Societys Benefit above Private
Benefit (D->)
Private suppliers underestimate the true value
Private market decides quantity by
Equating private cost to private benefit.

With underestimated benefit

Private market supplies too little.
Private market over-prices the good or service

Ex
Atde
drnea
dl
bBe
enn
ee. f
Dead Weight Loss
@it
@
de
S
5s0i
re
d
Benefit
Added Cost @
So
Social Optimum
ci
al
Be
Payment
ne
Cost
D
fit

Cons Surp = Bene - Payment

Prod Surp = Receipts Var Cost

Society Desired P & Q

Positive Externalities
(External Benefits) Graphically
Demand and Supply measure benefit and
cost for the parties to the transaction

External Benefit

If other people benefit, total benefit is greater than

the private benefit shown on the demand curve (D)

P
S

This additional benefit can be shown by

constructing a 2nd (total benefit) demand curve

P2
P1

With external benefits, total value

exceeds private value
D
Q1 Q2

D, including external benefit

Total value calls for Q2
Q

Private decisions lead to Q1

External benefits lead to lost surplus due to underproduction

Dead weight loss: Society benefit minus society cost
between Q where society is best off and private profit maximum Q.

Coase Theorem
If,
at no cost,
people can negotiate the purchase or sale of the right
to perform activities that cause externalities,
they can always arrive at efficient solutions to the
problems caused by externalities

Example:
Your roommate and you have different preferences
with respect to music
A negotiated sharing arrangement is efficient
I get my music in return for you getting yours

More realistic Coase Theorem

example
Selling pollution rights
Pollution is an external cost
Customers underestimate the true cost of
good
Charge the company for the right to pollute
Increases cost of product (lowering Q &
pollution)
Provides funds for cleaning up environment

Solutions to externalities
Laws affecting behavior
Traffic laws (limits external costs)
Zoning restrictions (+/- externalities)
Environmental Protection Administration (EPA)
(limits external costs)
Free Speech laws (+/- externalities)
Subsidizing purchase of non-polluting autos
(limits negative externalities)
Cap and Trade (in Europe and proposed here)

Tragedy of the Commons

The problem89
Unpriced resource is the problem
Example
Fishing in a pond
As I fish, I make it more expensive for others to
fish by decreasing the fish population
However, I do not see this
As many people do this, more fish are taken than
should be (each underestimates the true cost)

Tragedy of the Commons

The solution
Private ownership
If I own the pond, I can charge for the right to
fish
Increases cost of product to true cost
Lowers Q
Provides funds for restocking the pond

Governmental enforcement of limits

Positional Externalities
If the outcome is determined by my
relative position, others actions affect me
Can lead to cheating on test where there is a
curve
Can lead to over-advertising (prisoners
dilemma)
Can lead to positional arms race

Presidential election negativity, spending

Pro ball players salaries
Athletes use of steroids
Fashion (keep ahead of the Jones)

Nomination vs Election
Political Disribution of Pe ople

Number of People

Liberal

Conservative
Democrats

Republicans

Winning nomination vs winning election

Primary: appeal to constituents
Democrat, liberal;
Republican, conservative

Election: appeal to both constituents (center)

1992 (Perot), 2000 (Nader), 2004 (Nader)

McCain (2008) , Republican debates (2012)
Current Polarization of Parties
Why is the TEA party so unwilling to compromise?