Slide 1

Externalities Appendix 16A

• Externalities:» Externalities exist when benefits or costs fall on others who do

not contribute or are reimbursed.» Some externalities are welcome and others are disliked.

• Pecuniary Externalities:» When the spillover are purely reflected in prices

» Example: The fear of mad cow disease reduces beef prices and raises chicken prices, but no inefficiency occurs as they are reflected in market prices

• Resource Misallocation:» When not pecuniary, externalities harm resource allocation.

Urban blight leads to too little investment.2005 South-Western Publishing

Slide 2

The Coase TheoremThe Coase Theorem argues that, if the transaction costs

for private contracting between parties are very low, the problems of externalities will be resolved without governmental intervention efficiently.

Even if governments and the courts can assign property rights or duties however they wish, the solution is unaffected when transaction costs are low.

Consider a railroad that burns crops planted nearby.

Slide 3

Coase’s Railroad• Table 16A.1 panel A, when the RR has property rights. Farmer’s profits in the

upper triangle. Without contracting, the RR would run 2 trains per day and the Farmer would plant 10 acres.

• With contracting, Coase predicts that farmer would bribe the RR about $501 to reduce the number of trains to 1 per day. The farmer gets $900 - $401 = $499 which is better $300; RR gets $1,501 better than $1,500.

Farmer’s Gross ProfitsBy acres planted

Railroad’sGross Profits

By trains per day

0 10 20

0 1,500 1,600

0 0 0

0 900 400

1,000 1,000 1,000

0 300 -800

1,500 1,500 1,500

0

1

2

Slide 4

Coase’s Railroad• Table 16A.1 panel B, when the Farmer has property rights. Farmer’s profits in

the upper triangle. The Farmer would plant 20 acres & the RR would not run.

• With contracting, Coase predicts that RR would bribe the RR about $101 to reduce the acreage to 10. The farmer gets $1,500 + $101 = $1,601 which is better $1,600; RR gets $400 - $101 better than without contracting.

Farmer’s Gross ProfitsBy acres planted

Railroad’sGross Profits

By trains per day

0 10 20

0 1,500 1,600

0 0 0

0 1,500 1,600

1,000 400 -200

0 300 1,600

1,500 300 -900

0

1

2

Slide 5

Result of Coase’s Railroad Example

• Whether the RR had the property right or the rancher, the result was 10 acres and 1 train per day. Circled in both examples.

• This required a very low cost of contracting.• This is called Reciprocal Externalities.• We might expect that there would be many farmers and the costs

of transactions could be steep.» Class Action Suits – is a way to reduce the costs of a group» Strategic Holdouts – can raise the cost of negotiation if one

farmer wants even more of the payout

Slide 6

Coase Theorem with Farmers & Ranchers

a simple example• Cattle Ranchers» Suppose a fence costs

$500,000

» Suppose damage to corn is $100,000 by cattle

» What should happen? No fence will be built

• Corn Farmers» Suppose a fence costs

only $100,000

» Suppose damage to corn is $500,000 by the cattle

» What should happen? A fence will be built

Slide 7

But Property Rights Matterin a world with transaction costs

• It is often costly to arrange contracts between ranchers and farmers

• Suppose the fence costs more than the damage» If the property right to safe crops is established, the

farmer will want a fence regardless of cost. An uneconomic fence is constructed.

» If the property right is to open range grazing, the rancher will not want a fence. No fence is built.

» Therefore, who gets the property right matters!

Slide 8

Other Solutions to Externalities

• Solution by Prohibition.

• Solution by Regulatory Directive.

• Solution by Taxes and Subsidies.

• Solution by Sale of Pollution Rights.

• Solution by Merger

Slide 9

Externality and Urban Renewal

• Blighted areas persist in many cities

• Externalities are part of the explanation

• ROR for Jones and Smythe

• Who would spend a lot if others don’t contribute?

Jones’ ROR

.15 .20

.15 .08

.08 .10.20 .10

INVEST NOT INVEST

Smythe’sROR

INV

ES

T N

OT

IN

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ST

Neither will invest.Eminent Domain by city may

help to solve the prisoner’s dilemma