EC1450 Principles of Microeconomics - Externalities and Information

Externalities and Property Rights

The Tragedy of the Commons

• Introduced by Garrett Hardin in 1968.
• Occurs with shared, open-access resources.
• Individuals acting in self-interest deplete the resource due to inefficient outcomes.

Example 1: Public Pasture

• Farmers share a pasture for cattle.
• Problem: Each farmer adds more cattle to increase profit.
• The pasture has limited capacity; grass regeneration can't keep up.
• Outcome: Pasture degradation, inability to support cattle.
• Individual rationality leads to collective resource destruction.

Example 2: Chocolate Malted Milkshake

• Sam and Stan share a milkshake.

Example 3: Blackberries in a Public Park

• Free access leads to over-picking.

Deeper Analysis of the Tragedy of the Commons

• Scenario: 5 villagers own common grazing land.
• Each can invest 100 in a steer or a bond with a 13\% annual return.
• Steer value in year 2 depends on herd size.

Payoff for a Steer

• Villagers choose independently, knowing others' choices.
• First three villagers buy a steer; the fourth is indifferent; the fifth buys a bond.
• Total income: 13 \times 5 = $65

Efficiency Analysis

• Total net income: 65
• Is this efficient? No.
• Villagers impose external costs, reducing total income.

A Better Option: Internalizing Externalities

• Villagers act as one entity and divide returns.

• Acting as one internalizes external costs.
• Buy a steer only if its marginal benefit is at least 13.
• Optimal: One steer and four bonds.
• Total net income: 26 + (4 \times 13) = $78
• Net gain: 78 - 65 = $13

Private Property as a Solution

• Group acting as one internalizes the full cost.
• The single entity obtains 78 net income versus 65 when acting separately.
• Private property helps solve the Tragedy of the Commons.

Positional Externalities

Definition

• Payoffs depend on relative performance.
• An increase in one person’s performance reduces the expected reward of another.
• Examples: Grading on a curve, competitive sports, loud parties.
• Incentivize mutually offsetting investments, leading to inefficient outcomes.

Example: Football Players and Anabolic Steroids

• Game theory scenario: Jones vs. Smith

• Optimal outcome for the group: Both choose