Chapter 10

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• An external cost is a cost of an activity
that falls on people other than those who
pursue the activity
– Also called a negative externality
• An externality is the name given to an
external cost or external benefit of an
activity
• An external benefit is a benefit of an
activity received by people other than those
who pursue the activity
– Also called a positive externality

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• Externalities reduce economic efficiency
– Solutions to externalities may be efficient
– When efficient solutions to externalities are
not possible, government intervention or
other collective action may be used

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• Phoebe harvests and sells honey from her bees
– Bees pollinate the apple orchards
• No payments made to Phoebe
• The bees provide a free service to the local farmers
– Phoebe is giving away a service
• Private costs are equal to private benefits
– Social costs are less than social benefits

When external benefits exist,

maximizing private profits produces less
than the social optimum

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• Phoebe harvests and sells honey from her bees
• People at a neighboring school and nursing home are
bothered by bee stings
• The bees are a nuisance to the neighbors
– Phoebe is not paying all the costs of her honeybees
• Private costs are equal to private benefits
– Social costs are greater than social benefits

When external costs exist,

maximizing private profits produces more
than the social optimum
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 External Cost
No External Cost

Social MC
Price ($000s / ton)

Price ($000s / ton)

Private MC 2.3 $1,000/ton
2.0
Private
1.3 1.3 MC
D
D
12,000
Quantity (tons/year) 8,000 12,000
Quantity (tons/year) Private
Equilibrium
Deadweight loss from Social
pollution = $2 M/yr Optimum
10-6
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 Deadweight loss from
positive externality
XB
MBPVT + XB
MC
Price

MBSOC
MBPVT
Social
Demand

Private Demand
QPVT QSOC
Private Social
Equilibrium Quantity Optimum

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• With externalities, private market outcomes
do not achieve the largest possible
economic surplus
– Cash is left on the table
• For example, with monopolies, output is
lower than with prefect competition
– Introduction of coupons and rebates expands
the market
• With externalities, actions to capture the
surplus are likely
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• Abercrombie’s company dumps toxic
waste in the river
– Fitch cannot fish the river
– No one else is harmed
• Abercrombie could install a filter to
remove the harm to Fitch
– Filter imposes costs on Abercrombie
– Filter benefits Fitch
• Parties do not communicate
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 With Filter Without Filter

Abercrombie's Gains $100 / day $130 / day

Fitch's Gains $100 / day $50 / day

Total Gains $200 / day $180 / day

 Abercrombie does not install the filter

 Marginal cost of filter to Abercrombie is $30 per day
 The marginal benefit to Fitch is $50 per day
 There is a net welfare loss of $20 per day
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• Communication changes the outcome
– Fitch pays Abercrombie between $30 and
$50 per day to use the filter
– Net gain in total surplus of $20 per day
With Filter Without Filter

Abercrombie's Gains $100 / day $130 / day

Fitch's Gains $100 / day $50 / day

Total Gains $200 / day $180 / day

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• The Coase Theorem says that if people can
negotiate the right to perform activities that cause
externalities, they can always arrive at efficient
solutions to problems caused by externalities
– Negotiations must be costless
• Sometimes those harmed pay to stop pollution
– Fitch pays Abercrombie
• Sometimes polluter buys the right to pollute
– Abercrombie pays Fitch
• The adjustment to the externality is usually done
by the party with the lowest cost
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• Abercrombie’s company produces toxic
waste
– Laws prohibit dumping the waste in the river
UNLESS Fitch agrees
– New gains matrix

With Filter Without Filter

Abercrombie's Gains $100 / day $150 / day

Fitch's Gains $100 / day $70 / day

Total Gains $200 / day $220 / day

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• Abercrombie can pay Fitch up to $50 per day for
the right to pollute
– Fitch will accept any offer over $30 per day
• In this scenario, polluting is the right thing to do

With Filter Without Filter

Abercrombie's Gains $100 / day $150 / day

Fitch's Gains $100 / day $70 / day

Total Gains $200 / day $220 / day

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• Suppose the law makes polluters liable
for the cost of cleaning up their pollution
– Polluters get lower incomes
– Non-polluters get higher incomes
With Filter Without Filter

Abercrombie's Gains $100 / day $150 / day

Fitch's Gains $100 / day $70 / day

Total Gains $200 / day $220 / day

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• Ann and Betty are evaluating housing options
– 2-bedroom apartment for $600 per month OR
– 2 1-bedroom apartments for $400 per month each
• If the costs were the same, Ann and Betty would be
indifferent between the two arrangements
• The externality here is Ann's telephone usage is high
– She would pay up to $250 per month to be able to
use the phone whenever she wants
– Betty would pay up to $150 per month to get better
phone access
– No second phone line is possible

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• Live together if the benefits exceed the costs
$800 per month $600 per month $200 per month

Total Cost of Separate Total Cost of Rent Savings

Apartments Shared Apartment from Sharing

Ann's Cost of Betty's Cost of

Least-Cost
Problem Solving the Solving the
Solution
Problem Problem
Ann pays Betty
Ann's phone Pay Ann $250 to Pay Betty $150
$150 per
usage decrease usage to tolerate Ann
month

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 Cost of Phone
Rent Savings Gain in Surplus
Accommodation
$200 per month $150 per month $50 per month

• Ann and Betty will live together

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• Betty would spend $400 per month to
live alone
– The cost of tolerating Ann's phone use is
$150 per month
– Betty will be willing to pay up to $250 = $400
- $150 to live with Ann
• Above $250, she will be better off living alone
• Ann is willing to pay up to $400 per
month, the cost of living alone
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• Betty's maximum rent is $250
• Ann's maximum rent is $400
• If they divide the surplus ($50) equally,
– Betty pays $225 = $250 – $25
– Ann pays $375 = $400 – 25

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• If negotiation is costless, the party with
the lowest cost usually makes the
adjustment
– Private solution is generally adequate
• When negotiation is not costless, laws
may be used to correct for externalities
– The burden of the law can be placed on
those who have the lowest cost

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• Noise regulations (cars, parties, honking
horns)
• Most traffic and traffic-related laws
– Car emission standards and inspections
• Zoning laws
• Building height and footprint regulations
(sunshine laws)
• Air and water pollution laws
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 Free Speech Planting Trees
•First Amendment •Government subsidizes trees on
recognizes the value of private property
open communications
• Decreases chances of
• Hard to identify speech flooding and landslides
that has a net cost
• Net reduction of CO2 in the
•Some limitations
atmosphere
• Yelling "fire" in a crowded
theatre Basic Research
• Promote the violent • Millions of dollars spent by
overthrow of the federal government yearly
government
• Externalities of new knowledge
• Pornography

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MC & MB
MC

MC = MB Optimal amount
of pollution

MB

Q
Quantity of Pollution

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• When transaction costs prohibit
negotiation:
– Negative externalities result in overproduction
– Positive externalities result in underproduction
• A per unit tax on output can move the
market to the socially optimal output when
there is a negative externality
• A per unit subsidy on output can move the
market to the socially optimal output when
there is a positive externality
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 No Pollution Tax Pollution Tax
$1,000 / ton
Private MC + Tax

Price ($000s / ton)

Price ($000s / ton)

Social MC

2.3 XC Tax
2.0 2.0
Private Private MC
1.3 MC 1.3

D D

8,000 12,000 8,000 12,000

Quantity (tons/year) Quantity (tons/year)

Social Private After Tax Before Tax

Optimum Equilibrium Equilibrium Equilibrium
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 No Subsidy Subsidy

MC Subsidy MC

Price ($ / ton)
Price ($ / ton)

XB
14 14
10 10
Social Subsidized
8 Demand 8 Demand
Private Private
Demand Demand
12 16 12 16
Quantity Quantity
(000s tons/year) (000s tons/year)

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• When use of a communally owned resource has
no price, the costs of using it are not considered
– Use of the property will increase until MB = 0
– This is known as the tragedy of the commons
• Suppose 5 villagers own land suitable for
grazing
– Each can spend $100 for either a steer or a
government bond that pays 13%
– Villagers know what everyone before them has
done
– Steer graze on the commons
– Value of the steer in year 2 depends on herd size

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• Using the information in the table below, each
villager makes a decision
# Steers Selling Price per Steer Income per Steer
1 126 26
2 119 19
3 116 16
4 113 13
5 111 11
• The fourth is indifferent between the two assets
– He buys a steer
• The fifth buys a bond
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• The village has 4 steer feeding on the
commons for one year
– At the end of the year, 4 steer sell for $113
each
• Total revenue for the village is (5) (113)
= $565
– Outcome is the same as 5 bonds
• They could have done better

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 Selling Income per Total Cattle Marginal
# Steer
Price steer Income Income
1 126 26 26 26
2 119 19 38 12
3 116 16 48 10

 Net income from one bond after one year is $13

 Buy a steer only if its marginal benefit is at least $13
 First villager buys a steer and all others buy bonds
 Total net income is 26 + (4) (13) = $78
 A net gain of $13 compared to the first scenario
 Tragedy of the commons is the tendency for a resource
that has no price to be used until its marginal benefit is zero

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• The villagers decide to auction off the
rights to the commons
– Auction makes the highest bidder consider
the opportunity cost of grazing additional
steer
– Villagers can borrow and lend at 13%.
– One steer is the optimal number
• Winning bidder pays $100 for the right to
use the commons

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• The winning bidder starts the year
– Spends $100 in savings to buy a yearling steer
– Borrows $100 at 13% to get control of commons
• The winning bidder ends the year
– Sells the steer for $126
• Gets original $100 back
• $13 opportunity cost of buying a steer
• $13 interest on loan for the commons
• Economic surplus of the village is
(4 x $13) + $26 = $78

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 Blackberries in the Park
•Sweetness increases as the
berry ripens
•Blackberries are common
property
– Berries will be eaten before
they are fully ripe
Other Examples
•Harvesting
– Timber on remote public
land
– Whales in open oceans
•Worldwide pollution controls
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Shared Milkshakes
•Milkshakes chill taste buds
– Decrease appreciation of its
flavor
– Drinking slowly increases
appreciation
•If two people share the
milkshake, it is a common
good
– They will drink faster than if
it were a private good
10-34
• Highest compensation goes to the best
performer
– Standard is relative, not absolute
• Each player increases spending to
increase probability of winning
– Sum of all these investments > collective
payoff
• Total payout is fixed, so players' group has no
gains

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 • Smith and Jones compete for one $1 million
contract
– Each has 50% chance at the contract
• Smith and Jones have a Prisoner's Dilemma
Jones's Options

Smith's Options No Steroids Steroids

Worst for Smith

No Steroids 2nd best for each
Best for Jones
Best for Smith
Steroids 3rd best for each
Worst for Jones

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• Relative performance determines reward
– Positional externalities occur when an increase in
one person's performance reduces the expected
reward of another
• A positional arms race is a series of mutually
offsetting investments in performance
enhancement that is stimulated by a positional
externality
– A positional arms control agreement attempts to
limit the mutually offsetting investments in
performance enhancements by contestants
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• Campaign spending limits
• Roster limits
• Arbitration agreements
• Mandatory starting dates for kindergarten
• Social Norms as Positional Arms Control
Agreements
– Nerd norms
– Fashion norms
– Norms of taste
– Norms against vanity

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• Tragedy of the Commons: individual right of use, but
no right of exclusion
• Tragedy of the Anti-commons: Individual right of
exclusion but no autonomous right of use
• Hold-out and hold-up problems
• Examples: research, pharmaceutical companies,
highway construction through private properties,
international financial crises and refugee crisis.

10-41
 The Tragedy of the Anti-Commons (2)

• An example
• One pharmaceutical company (PhC) and two patent
holders (PHs) of drug components. PhC faces demand
Q  1  P and incurs costs C(Q)  cQ  w1Q  w2Q
where w1 and w2 are the royalty fees charged separately by
the patent holders. PhC strives for maximum profits:

max (1  Q)Q  c  w1  w2 Q  1  2Q  c  w1  w2   0

Q

1  c  w1  w2 
Q
2
10-42
 The Tragedy of the Anti-Commons (3)

1  c  w1  w2 
• Each PH faces demand Q
2
and maximizes her own benefit:
1  c  w1  w2   1  c  w1  w2  
max  w1  and max  w2 
w1
 2  w2
 2 

• The first order conditions yield:

1 c 1 c 5c
w1  w2  Q ,P ,
3 6 6
1 c  1 c  1 c 
2 2 2

 PhC   ,  PH       PhC   PH  5 
 6   3   6 

10-43
 The Tragedy of the Anti-Commons (4)

• Had the PHs merged the PhC’s profit

maximization would become:
max (1  Q)Q  c  wQ  1  2Q  c  w  0
Q

1  c  w
Q
2

• The PH’s objective function would be:

1  c  w  1 c 1 c 3 c
max  w  w  Q ,P ,
w
 2  2 4 4
1 c  1 1 c  1 c 
2 2 2

 PhC    ,  PH    ,   3 
 4  2  2   4 
10-44
• Comparing Qs and Ps shows that less rather than
more competition would result in larger
quantities and lower prices.
• Comparing the PhC’s and the PHs’ profits shows
that all of them would earn larger profits after
than before the merger.
• Tragedy of the Commons: underpricing and over-
production
• Tragedy of the Anti-Commons: overpricing and
under-production

10-45