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Assigning property rights

Set policy prescription, such as:

Set standards on pollution allowed

Tax polluter equal to MEC at QE

Establish a market and price for pollution

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Common Property Resources are those for which property rights are shared.

Because property rights extend to more than one individual, they are not as clearly defined as for pure private goods.

Problem is that public access without any control leads to exploitation, which in turn generates a negative externality.

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(b) Bargaining When Rights Belong to Recreational Users

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(b) Bargaining When Rights Belong to Recreational Users

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Bargaining will proceed analogously

An efficient outcome can be realized without government intervention

Limitations of the Coase Theorem

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(a) Bargaining When Rights Belong to Refineries

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(a) Bargaining When Rights Belong to Refineries

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Recreational users are willing to pay (WTP) refineries for each unit of Q not produced

Will pay up to the negative effect on utility (MEC)

Refineries are willing to accept payment not to produce

Will accept payment greater than their loss in profit from contracting production (Mp)

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Refineries use the river to release chemicals as an unintended by-product of production.

Objective: to maximize p

Recreational users use the river for swimming and boating.

Objective: to maximize utility

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Proper assignment of property rights, even if externalities are present, will allow bargaining between parties such that efficient solution results, regardless of who holds rights.

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Valid claims to a good or resource that permit the use and transfer of ownership through sale.

For environmental goods, it’s unclear who “owns” rights.

Economics says it’s the absence of rights that matters, not who possesses them.

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Both externality and public goods models show inefficiency of private market solution, i.e., market failure.

Underlying source of failure is absence of property rights.

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(a) Measuring Society’s Net Gain (from restoring efficiency)

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(a) Measuring Society’s Net Gain (from restoring efficiency)

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As Q falls from 160 to 128:

Refineries lose p measured as Mp (or excess of MPB over MPC) for each unit of Q contracted (Defines area WYZ)

Society gains accumulated reduction in MEC for each unit of Q contracted (Defines area WXYZ)

Net gain =Area WXYZ - Area WYZ =Area WXY

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Analysis
QC = 160 thousand

At this point, MEC = $8.00 per barrel (Note Mp ¹ MEC Þ not efficient)

QE = 128 thousand

At this point, MEC = Mp = $6.40 per barrel

Efficiency would improve if output were restricted by 32 thousand (i.e., 160 - 128)

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(a) Comparing the Equilibria (Using Mp and MEC)

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(a) Comparing the Equilibria (Using Mp and MEC)

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Competitive firm maximizes p where

MPB = MPC, or where MPB - MPC = 0, or

Mp = 0

(since MPB – MPC = Mp by definition)

Efficient firm produces where

MSB = MSC or MPB + MEB = MPC + MEC

or MPB - MPC = MEC, if MEB = 0, so…

Mp = MEC

Model

Mp = MPB - MPC = (42 - 0.125Q) - (10 + 0.075Q) so

Mp = 32 - 0.2Q

MEC = 0.05Q

Solution
Competitive solution

Set Mp = 0, or 32 - 0.2Q = 0, so QC = 160

Find P by substituting into MPB or MPC (Using MPB, PC = 42 – 0.125(160) = 22)

Efficient solution

Set Mp = MEC, or 32 - 0.2Q = 0.05Q, so QE= 128

Find P by substituting into MPB or MPC (Using MPB, PE = 42 – 0.125(128) = 26)

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QC is too high, i.e., overallocation of resources

PC is too low, since MEC is not captured by market transaction

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(a) Finding Competitive Solution
S: P = 10.0 + 0.075Q
D: P = 42.0 - 0.125Q, where Q is thousands of barrels per day.
Since S is MPC and D is MPB, rewrite as:
MPC = 10.0 + 0.075Q
MPB = 42.0 - 0.125Q

Solution
Set MPB = MPC
42.0 - 0.125Q = 10.0 + 0.075Q

Solve: QC = 160 thousand PC = $22 per barrel
Analysis:

This ignores external costs from contamination

Allocative efficiency requires P to equal all MC

MPC undervalues opportunity costs of production; QC is too high; PC is too low

(b) Finding an Efficient Solution
Let Marginal External Cost (MEC) = 0.05Q
Marginal Social Cost (MSC) = MPC + MEC
MSC = 10.0 + 0.075Q + 0.05Q
= 10.0 + 0.125Q
Marginal Social Benefit (MSB) = MPB + MEB
Assuming no external benefits, MEB= 0, so MSB = MPB

Solution
Set MSC = MSB
10.0 + 0.125Q = 42.0 - 0.125Q
Solving: QE = 128 thousand PE = $26/barrel
Observe: In the presence of an externality, market forces cannot determine an efficient outcome

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Assume the market is competitive

Supply is the marginal private cost (MPC).

Production generates pollution, modeled as a marginal external cost (MEC).

Problem: Producers (refineries) have no incentive to consider the externality.
Result: Competitive solution is inefficient.

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Relationship between Public Goods & Externalities

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Relationship between Public Goods & Externalities

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If the externality affects a broad segment of society and if its effects are nonrival and nonexcludable, the externality is itself a public good.

If the externality affects a narrower group of individuals or firms, those effects are more properly modeled as an externality.

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a spillover effect associated with production or consumption that extends to a third party outside the market.

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(negative externality)

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Solution to Public Goods (Gov Intervention)

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Solution to Public Goods (Gov Intervention)

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respond through direct provision of public goods.

use political procedures and voting rules.

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Result is that market demand is undefined.

lack of awareness of environmental problems (i.e., imperfect information) exacerbates the problem.

allocative efficiency cannot be achieved without third-party intervention.

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market D for a public good is found by vertically summing individual demands.

but consumers are unwilling to reveal their WTP because they can share in consuming the public good even when purchased by someone else.

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good whose production or consumption generates environmental damage.

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environmental quality

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the result of an inefficient market condition.