EC1450 Principles of Microeconomics - Externalities and Property Rights

Externalities and Property Rights (Chapter 11)

Reminders

• Additional Assignment on The Prisoner’s Dilemma due Tuesday April 8th
• Connect HW assignment on Externalities due Thursday April 10th

Externalities

• An externality is defined as an external cost or external benefit of an activity that affects third parties, i.e., individuals not directly involved in the activity.

Externalities and Market Failures

• When externalities (costs or benefits) exist, market outcomes are not efficient.
• Negative Externality: Too much of the good or activity is produced.
• Positive Externality: Too little of the good or activity is produced.

What To Do About Externalities?

Ronald Coase

• Nobel Prize in Economics, 1991

Ronald Coase and The Problem of Social Cost

• In “The Problem of Social Cost,” Journal of Law and Economics (1960), Coase posits that under the assumption of frictionless markets (markets that can be used at no cost), the involved parties will solve the problem without government intervention. This is known as The Coase Theorem.

The Coase Theorem

• In a world of zero transaction costs, parties will bargain around externalities and reach an efficient outcome, negating the necessity for government intervention.
• Transaction Costs: The costs of using the price mechanism.

Transaction Costs Include

• Searching for information about price and quality of goods or services. This includes searching for potential buyers or sellers and for any relevant information about their behavior.
• Bargaining to find the true position of buyers and sellers.
• Making contracts.
• Monitoring contractual partners to ensure they abide by the terms of the contract.
• Enforcing a contract and collecting damages when partners fail to observe their contractual obligations.

Factors Affecting Transaction Costs

• Type of Good
  • Common goods versus unique goods influence transaction costs.
• Timing and Complexity
  • Instantaneous exchanges generally have lower transaction costs.
• Number of People Involved
  • The fewer the number of people, the lower the transaction costs.

Coase Theorem Example

• Consider a cattle rancher and a grain farmer as neighbors without a physical boundary between their properties.
• The rancher’s cattle may wander onto the farmer’s property, causing damage to crops.

Coase Theorem Scenario

• Farmer can build/maintain a fence at an annual cost of 95.
• Rancher can build/maintain a fence at an annual cost of 120.
• Without a fence, cattle reduce the farmer’s profit by 180 per year.
• Most efficient outcome: Farmer builds a fence for 95.

Coase Theorem Outcomes

• No Law Protecting the Farmer
  • The farmer will build the fence around his land, which is the efficient outcome, as it is cheaper than the losses from trespassing cattle.
• “No-Trespassing” Law Protecting the Farmer
  • Depends on Transaction Costs (T.C.).
  • If T.C. are high, the rancher builds the fence around his land (inefficient outcome).
  • If T.C. are zero, the rancher will build the fence on the farmer’s land through bargaining and sharing the cooperative surplus (efficient outcome).

Cooperative Surplus

• The gains from cooperation.
• External cost: 180
• Cost of fence around farmer’s land: 95
• Cost of fence around rancher’s property: 120
• Cooperative Surplus is 25 (120 - 95 = 25)

Conclusion on Coase Theorem

• When transaction costs are zero, an efficient allocation of resources will be obtained regardless of the initial allocation of rights (farmer’s rights or rancher’s rights):
  • Under a rancher’s rights regime, the farmer builds the fence around their land.
  • Under a farmer’s rights regime, the rancher builds the fence around the farmer’s land.

Initial Allocation of Rights and Wealth Distribution

• The initial allocation of rights always matters for the distribution of wealth.
  • Under farmer’s rights regime, the fence is paid for by the rancher.
  • Under rancher’s rights regime, the fence is paid for by the farmer.

Application of the Coase Theorem

• Roommate plays guitar at night, willing to pay up to 5 to play for an hour.
• You need to study and are willing to pay up to 6 an hour for quiet.
• Coase Theorem prediction: If T.C. are zero, you will bargain, and your roommate will not play the guitar.

Additional Thoughts on the Coase Theorem

• In reality, transaction costs are very rarely zero.
• Many factors prevent people from bargaining towards the efficient solution (e.g., social norms).
• The Coase Theorem is highly relevant because in a world of high T.C., the assignment of property rights (the legal system) matters for efficiency!

Potential Remedies When Negotiation Is Costly

• When T.C. are high, the government can help.
• When the value of the externality is relatively high, government intervention can be efficiency enhancing.
  • Taxes or subsidies: Taxing negative externalities or subsidizing positive ones (Pigou).
  • Regulations. Regulate negative externalities. Examples:
    • Zoning laws (e.g., no factories in residential neighborhood).
    • Pollution laws (e.g., prohibition of discharge of toxic wastes into rivers).
    • Noise regulations (e.g., no honking horns around hospitals).

In-Class Assignment: Card Players and Cigar Smoke

• Ten people in a room; one wants to smoke a cigar.
• Smoker values the privilege at 6, nine others would pay 0.50 for clean air.
• Smoking is not allowed unless everyone agrees.
• Outcome consistent with the Coase Theorem: The smoker smokes.
• The smoker values smoking for 6, and the rest of the group values the right at 4.50.
• The efficient outcome is for the smoker to smoke since the smoker can pay each person 0.60, costing him a total of 5.40 to get the right to smoke.

Jones and Smith Payoff Example

• Jones emits smoke, Jones Payoff = 200, Smith Payoff = 400, Total = 600
• Jones does not emit smoke, Jones Payoff = 160, Smith Payoff = 420, Total = 580
• Efficient outcome: Jones emits smoke (combined payoffs greater)
• Cooperative surplus: 20 = 600 - 580
• If divided evenly, they get 10 more each: 170 for Jones, 430 for Smith

Property Rights and the Tragedy of the Commons

Property Rights

• A bundle of rights that describe what one can do with the assets one possesses:
  • The right to use it
  • The right to earn income from it
  • The right to transfer it, etc.

The Need for Property Rights: A Thought Experiment

• Two neighboring farmers, each can farm their own land or steal crops from their neighbor.

Payoff Matrix

• Planting/watering costs 5, crops worth 15, stealing costs 3

• Payoff Matrix:

  	Farm	Steal
  Farm	10, 10	-5, 12
  Steal	12, -5	0, 0

• Dominant Strategy: Both players STEAL

Instituting Property Rights

• Punish people who steal to institute property rights, but setting up the system would cost something (cost \"c\" on everyone).

Modified Game with Property Rights

• Payoff Matrix:

  	Farm	Steal
  Farm	10 – c, 10 – c	-5 – c, 12 – P
  Steal	12 – P, -5 – c	-P, -P

• \"c\" is the cost of enforcing the system, and \"P\" is the penalty for stealing.

• If P is big, and c is not too big, (Farm, Farm) can be an equilibrium.

Thought Experiment Takeaway

• Anarchy (the absence of Property Rights) is inefficient.
• Individuals spend time and effort protecting their possessions or stealing from others.
• We all could be focused on productive work instead!