Announcements• Reminder: Jake’s section from Monday wasrescheduled to today, 5:30-6:30 pm in Econ304.• Homework 4 will be a practice exam– Posted on about Friday (one week beforemidterm), ungraded.
Last Time• Introduced basic idea of externalities.• Showed that private decision at odds withpublic interest, caused inefficiency.• Stated that free market solutions mightrectify: The Coase theorem.
The Coase Theorem• If an outcome is not socially optimal, that means that at leastsome people can be made better off without harming anyone• 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.
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 eachother, what will the outcome be?Don’t Play MusicAfter 10pmPlay MusicAfter 10pmGains to Barack $50/month $70/monthGains to Mitt $50/month $10/month
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
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
Example3• Now it’s socially optimal to play music after 10pm• Suppose the law still gives Mitt the right to make Barack stopplaying music.Don’tPlay MusicAfter 10pmPlay MusicAfter 10pmGains to Barack $50/month $70/monthGains to Mitt $50/month $40/month
Which solution achieves efficiency?A. It will be achieved automatically.B. It will never be achieved.C. Mitt pays Barry $10.01D. Barry pays Mitt $10.01Don’tPlay MusicAfter 10pmPlay MusicAfter 10pmGains to Barack $50/month $70/monthGains to Mitt $50/month $40/month
The Role of Property Rights• Example 1– 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.• Examples 2 and 3– 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.
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?
Legal Remedies• Negotiation is not always costless.– Not fun to get up in the middle of the night to negotiatewith your neighbor who’s playing loud music so you cansleep.– How do the safe drivers on a highway flag down aspeeding motorist (whose behavior is endangering others)to negotiate with her?– How do you trust people to live up to their end of thebargain?• This opens the door for the government to impose laws thatincrease total surplus.
Examples of Laws that Solve ProblemsCreated by Externalities• Noise ordinances that set quiet hours for neighborhoods.• Speed limits& no-passing zones.• Laws regarding broken headlights, taillights etc.• Zoning laws—can’t build loud factories in residential areas.• Pollution laws.• Seat belt laws.• Laws against theft, assault, murder.• Building codes—how high can buildings be, and how closeto the property line?• No talking on your cell phone in your car (or in class).
Taxing Negative ExternalitiesPQSDPQSDS+XC S+TaxXC=$100 per unit Tax=$100 per unitAlso called a Pigouvian tax.Example: Pay for Carbon output.
Subsidizing Positive ExternalitiesPQSDPQSDD+XB D+SubsidyXB=$100 per unit subsidy=$100 per unitExample: Financial aid!
Positional Externalities• Positional externalities occur when an increase in one person’sperformance reduces the expected reward of another person insituations in which reward depends on relative performance.• Occurs in many competitive situations.• People make investments to increase their relative standing, butthe cost of all those investments is likely to outweigh the collectivepayoff—after all, only one person can be #1!• Often leads to a prisoner’s dilemma.
Why would Lance dope?• Lance Armstrong recentlydecided not to fight the U.S.Doping Agency’s allegationsthat he used performanceenhancing drugs.• Taken as a implicit admissionthat the allegations are true.
Why Would Lance Dope?LanceDon’tDopeDopeAlbertoDon’tDopeSecond bestfor eachWorst for AlbertoBest for LanceDopeBest for AlbertoWorst for LanceThird bestfor each
Poor Lance?• Should we really blame the guy just because he knows a Nashequilibrium when he sees one?A. YesB. No• Maybe, but according to the World Anti-Doping Code– Armstrong will be stripped of his seven Tour titles, bronze medalhe won at the 2000 Olympics andall other titles, awards andmoney he won from August 1998 forward.– Armstrong also will be barred for life from competing, coachingor having any official role with any Olympic sport or other sportthat follows the World Anti-Doping Code.– Recently stepped down as Chair of the Board of Directors ofLivestrong.
Other Examples• Arms races (arms agreements)• Campaign spending (campaign spending limits)• Sports gear (ban on high-tech full-body suits for swimmers)• Educational attainment & study habits (“nerd”)• The “rug-rat race” (accusations of being a “helicopter parent”)• Edgy tatoos and piercings (social norms)• Nudity, sex, violence in the media (social norms)