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  1. 1. ExternalitiesApril 22, 2013
  2. 2. Announcements• Homework 3 is due; pass to aisle!• I have old problem sets in my office if youdidn’t pick them up last week.– Friday 12:30-2:30 SEQ 236
  3. 3. Last Time• Finished discussion of game theory withrefinements.• If you were not in class on Friday, pleaseplease talk to somebody who was.
  4. 4. Externalities• External benefit: a benefit of an activity received by peopleother than those who pursue the activity.– Also know as: positive externality– Example: bee farm next to apple orchard, antibiotic use• External cost: a cost of an activity that falls upon people otherthan those who pursue the activity.– Also known as: negative externality– Example: polluting factory, antibiotic use
  5. 5. Positive ExternalityAntibiotic UsePQSDD+XB
  6. 6. Negative ExternalityAntibiotic UsePQSDD-XB
  7. 7. Consumption and ProductionExternalities• The last two slides showed consumption externalities—external costs or benefits that arose from the consumption ofa good or service.– Typically modeled as a shift in the demand curve.• There are also production externalities—external costs orbenefits that arise because of the production of a good orservice.– Typically modeled as a shift in the supply curve.
  8. 8. Examples of Production Externalities• Bee keepers whoproduce honey alsobenefit the owners offruit orchards.• Production processesthat pollute theenvironment, impose acost upon everyone else.PQSDPQSD
  9. 9. Does it Matter?• A good with positive externalities (consumption orproduction) will be underproduced.• A good with negative externalities (consumption orproduction) will be overproduced.• All externalities distort the allocation of resources inotherwise efficient markets—and the individual pursuit of selfinterest will not result in the largest possible economicsurplus.
  10. 10. The Coase Theorem• If an outcome is not socially optimal, that means that at leastsome people can be made better off without harminganyone—there’s “cash on the table”.• This creates an incentive for individuals to take steps toimprove the situation.• The Coase Theorem: If at no cost people can negotiate thepurchase and sale of the right to perform activities that causeexternalities, then can always arrive at efficient solutions tothe problems caused by externalities.
  11. 11. Example• Suppose Barack likes to play loud music late at night, but itdisturbs his neighbor Mitt. Barack could stop playing musiclate at night, but he enjoys doing this. The table below showstheir monthly enjoyment from being at home under differentscenarios.• Suppose Barack and Mitt can’t negotiate with each other,what will the outcome be?Don’t Play MusicAfter 10pmPlay MusicAfter 10pmGains to Barack $50/month $70/monthGains to Mitt $50/month $10/month
  12. 12. Example 1• Now suppose they can easily negotiate with each other, whatwill the outcome be?• One possibility: Mitt could offer Barack $30 per month to stopplaying music.Don’t Play MusicAfter 10pmPlay MusicAfter 10pmGains to Barack $50/month $70/monthGains to Mitt $50/month $10/month
  13. 13. Example 2• Now suppose they can still easily negotiate with each other,but the law gives Mitt the right to make Barack stop playingmusic. What will the outcome be?• Barack won’t play music.Don’t Play MusicAfter 10pmPlay MusicAfter 10pmGains to Barack $50/month $70/monthGains to Mitt $50/month $10/month
  14. 14. Example3• Now it’s socially optimal to NOT play music after 10pm, butsuppose the law still gives Mitt the right to make Barack stopplaying music.• Will Mitt make Barack stop playing music?• If the two parties can negotiate, a more likely outcome mightbe:Don’tPlay MusicAfter 10pmPlay MusicAfter 10pmGains to Barack $50/month $70/monthGains to Mitt $50/month $40/month
  15. 15. The Role of Property Rights• Compare examples 1 and 3.– Regardless of whom the law favors, the efficient outcome isachieved.– It didn’t matter whether Barack had the right to play music, theefficient solution was always achieved.• Compare examples 1 and 2– Laws do matter for the distribution of the surplus.– When Barack has the right to play music, he’s better off thanwhen the law requires him to stop playing music.
  16. 16. Legal Remedies• The Coase Theorem tells us that efficient solutions to externalitiescan be found when parties can easily (at no cost) negotiate witheach other.• What role do laws play in dealing with externalities?• Is there any need for government intervention?