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- 2. Announcements • Homework 3 is due; pass to aisle! • I have old problem sets in my office if you didn’t pick them up last week. – Friday 12:30-2:30 SEQ 236
- 3. Last Time • Finished discussion of game theory with refinements. • If you were not in class on Friday, please please talk to somebody who was.
- 4. Externalities • External benefit: a benefit of an activity received by people other 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 other than those who pursue the activity. – Also known as: negative externality – Example: polluting factory, antibiotic use
- 7. Consumption and Production Externalities • The last two slides showed consumption externalities— external costs or benefits that arose from the consumption of a good or service. – Typically modeled as a shift in the demand curve. • There are also production externalities—external costs or benefits that arise because of the production of a good or service. – Typically modeled as a shift in the supply curve.
- 8. Examples of Production Externalities • Bee keepers who produce honey also benefit the owners of fruit orchards. • Production processes that pollute the environment, impose a cost upon everyone else. P Q S D P Q S D
- 9. Does it Matter? • A good with positive externalities (consumption or production) will be underproduced. • A good with negative externalities (consumption or production) will be overproduced. • All externalities distort the allocation of resources in otherwise efficient markets—and the individual pursuit of self interest will not result in the largest possible economic surplus.
- 10. The Coase Theorem • If an outcome is not socially optimal, that means that at least some people can be made better off without harming anyone—there’s “cash on the table”. • This creates an incentive for individuals to take steps to improve the situation. • The Coase Theorem: If at no cost people can negotiate the purchase and sale of the right to perform activities that cause externalities, then can always arrive at efficient solutions to the problems caused by externalities.
- 11. Example • Suppose Barack likes to play loud music late at night, but it disturbs his neighbor Mitt. Barack could stop playing music late at night, but he enjoys doing this. The table below shows their monthly enjoyment from being at home under different scenarios. • Suppose Barack and Mitt can’t negotiate with each other, what will the outcome be? Don’t Play Music After 10pm Play Music After 10pm Gains to Barack $50/month $70/month Gains to Mitt $50/month $10/month
- 12. Example 1 • Now suppose they can easily negotiate with each other, what will the outcome be? • One possibility: Mitt could offer Barack $30 per month to stop playing music. Don’t Play Music After 10pm Play Music After 10pm Gains to Barack $50/month $70/month Gains to Mitt $50/month $10/month
- 13. Example 2 • Now suppose they can still easily negotiate with each other, but the law gives Mitt the right to make Barack stop playing music. What will the outcome be? • Barack won’t play music. Don’t Play Music After 10pm Play Music After 10pm Gains to Barack $50/month $70/month Gains to Mitt $50/month $10/month
- 14. Example3 • Now it’s socially optimal to NOT play music after 10pm, but suppose the law still gives Mitt the right to make Barack stop playing music. • Will Mitt make Barack stop playing music? • If the two parties can negotiate, a more likely outcome might be: Don’tPlay Music After 10pm Play Music After 10pm Gains to Barack $50/month $70/month Gains to Mitt $50/month $40/month
- 15. The Role of Property Rights • Compare examples 1 and 3. – Regardless of whom the law favors, the efficient outcome is achieved. – It didn’t matter whether Barack had the right to play music, the efficient 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 than when the law requires him to stop playing music.
- 16. Legal Remedies • The Coase Theorem tells us that efficient solutions to externalities can be found when parties can easily (at no cost) negotiate with each other. • What role do laws play in dealing with externalities? • Is there any need for government intervention?