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HE9091

Principles of Economics
Lecture 5
Externalities, Property Rights
and Economics of
Information
Tan Khay Boon
Email: khayboon@ntu.edu.sg
Office: HSS-04-25
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Topics
External Costs and Benefits
The Coase Theorem
Property Rights and the Tragedy of the
Commons
Optimal Amount of Information
Asymmetric Information
Adverse Selection and Moral Hazard
Reference: FBLC, chapters 10 & 11
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External Costs and Benefits
An external cost is a cost of an activity that falls
on people other than those who pursue the
activity
Also called a negative externality
An externality is the name given to an external
cost or external benefit of an activity
An external benefit is a benefit of an activity
received by people other than those who pursue
the activity
Also called a positive externality
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Externalities Affect Resource
Allocation
Externalities reduce economic efficiency
Solutions to externalities may be efficient
When efficient solutions to externalities are not
possible, government intervention or other collective
action may be used
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Honeybee Keeper Scenario 1
Phoebe harvests and sells honey from her bees
Bees pollinate the apple orchards
No payments made to Phoebe
The bees provide a free service to the local
farmers
Phoebe is giving away a service
Private costs are equal to private benefits
Social costs are less than social benefits
When external benefits exist,
maximizing private profits produces less
than the social optimum
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Honeybee Keeper Scenario 2
Phoebe harvests and sells honey from her bees
People at a neighboring school and nursing
home are bothered by bee stings
The bees are a nuisance to the neighbors
Phoebe is not paying all the costs of her honeybees
Private costs are equal to private benefits
Social costs are greater than social benefits
When external costs exist,
maximi zing private profits produces more
than the social optimum
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External Cost
Quantity (tons/year)
12,000
1.3
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D
Private
MC
$1,000/ton
External Costs
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No External Cost
Quantity (tons/year)
12,000
1.3
D
Private
MC
Private
Equilibrium
Deadweight loss from
pollution = $2 M/yr
Social
Optimum
2.3
Social MC
2.0
8,000
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Positive Externality for
Consumers
Deadweight loss from
positive externality
XB
MB
PVT
+XB
Social
Demand
MB
SOC
Q
SOC
P
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Quantity
Private Demand
MC
Q
PVT
MB
PVT
Private
Equilibrium
Social
Optimum
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Effects of Externalities
With externalities,
private market outcomes
do not achieve
the largest possible economic surplus
Cash is left on the table
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Remedying Externalities
With externalities, private market outcomes do
not achieve the largest possible economic
surplus
Consider monopolies where output is lower and
price is higher than perfect competition
Introduction of coupons and rebates expands the
market
With externalities, actions to capture the surplus
are likely
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Abercrombie the Polluter
Scenario 1
Abercrombies company dumps toxic waste in the
river
Fitch cannot fish the river
No one else is harmed
Abercrombie could install a filter to remove the
harm to Fitch
Filter imposes costs on Abercrombie
Filter benefits Fitch
Parties do not communicate
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Abercrombie's Filter Options
With Filter Without Filter
Abercrombie's Gains $100 / day $130 / day
Fitch's Gains $100 / day $50 / day
Total Gains $200 / day $180 / day
Abercrombie does not install the filter
Marginal cost of filter to Abercrombie is $30 per day
The marginal benefit to Fitch is $50 per day
There is a net welfare loss of $20 per day
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Abercrombie the Polluter
Scenario 2
Communication changes the outcome
Fitch pays Abercrombie between $30 and $50 per
day to use the filter
Net gain in total surplus of $20 per day
With Filter Without Filter
Abercrombie's Gains $100 / day $130 / day
Fitch's Gains $100 / day $50 / day
Total Gains $200 / day $180 / day
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The Coase Theorem
The Coase Theorem says that if people can
negotiate the right to perform activities that cause
externalities, they can always arrive at efficient
solutions to problems caused by externalities
Negotiations must be costless
Sometimes those harmed pay to stop pollution
Fitch pays Abercrombie
Sometimes polluter buys the right to pollute
Abercrombie pays Fitch
The adjustment to the externality is usually done by
the party with the lowest cost
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Abercrombie the Polluter
Scenario 3
Abercrombies company produces toxic waste
Laws prohibit dumping the waste in the river
UNLESS Fitch agrees
New gains matrix
With Filter Without Filter
Abercrombie's Gains $100 / day $150 / day
Fitch's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
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Abercrombie the Polluter
Scenario 3
Abercrombie can pay Fitch up to $50 per day for
the right to pollute
Fitch will accept any offer over $30 per day
In this scenario, polluting is the right thing to do
With Filter Without Filter
Abercrombie's Gains $100 / day $150 / day
Fitch's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
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Laws Can Change the Outcome
Suppose the law makes polluters liable for the
cost of cleaning up their pollution
Polluters get lower incomes
Non-polluters get higher incomes
With Filter Without Filter
Abercrombie's Gains $100 / day $150 / day
Fitch's Gains $100 / day $70 / day
Total Gains $200 / day $220 / day
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Shared Living
Ann and Betty are evaluating housing options
2-bedroom apartment for $600 per month OR
1-bedroom apartment for $400 per month each
If the costs were the same, Ann and Betty would be
indifferent between the two arrangements
The externality here is Ann's telephone usage is high
She would pay up to $250 per month to be able to
use the phone whenever she wants
Betty would pay up to $150 per month to get better
phone access
No second phone line is possible
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Benefits and Costs of Shared
Living
$800 per month $600 per month $200 per month
Total Cost of Separate
Apartments
Total Cost of
Shared Apartment
Rent Savings
from Sharing
Live together if the benefits exceed the costs
Problem
Ann's Cost of
Solving the
Problem
Betty's Cost of
Solving the
Problem
Least-Cost
Solution
Ann's phone
usage
Pay Ann $250 to
decrease usage
Pay Betty $150
to tolerate Ann
Ann pays Betty
$150 per
month
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Net Benefit of Shared Living
Ann and Betty will live together
$200 per month $150 per month $50 per month
Rent Savings
Cost of Phone
Accommodation
Gain in Surplus
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Dividing the Rent
Betty would spend $400 per month to live alone
Cost of tolerating Ann's phone use is $150 per month
Betty willing to pay up to $250 = $400 - $150 to live
with Ann. Above $250, she will live alone
Ann is willing to pay up to $400 per month, the
cost of living alone
Betty's maximum rent is $250
Ann's maximum rent is $400
If they divide the surplus ($50) equally,
Betty pays $225 = $250 $25
Ann pays $375 = $400 25
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Legal Remedies for
Externalities
If negotiation is costless, the party with the lowest
cost usually makes the adjustment
Private solution is generally adequate
When negotiation is not costless laws may be
used to correct for externalities
The burden of the law can be placed on those who
have the lowest cost
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Legal Remedies for Externalities
Noise regulations (cars, parties, honking horns)
Most traffic and traffic-related laws
Car emission standards and inspections
Zoning laws for schools
Building height regulations
Air and water pollution laws
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Optimal Amount of Negative
Externalities
Quantity of Pollution
MC & MB
MC
Q
MC =MB
MB
Optimal amount
of pollution
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Taxes and Subsidies
When transaction costs prohibit negotiation:
Negative externalities result in overproduction
Positive externalities result in underproduction
A per unit tax on output can move the market to
the socially optimal output when there is a
negative externality
A per unit subsidy on output can move the
market to the socially optimal output when there
is a positive externality
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Quantity (tons/year)
P
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(
$
0
0
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t
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D
Private MC
12,000
1.3
Pollution Tax
$1,000 / ton
Taxing a Negative Externality
Tax
Private MC +Tax
2.3
2.0
8,000
2.0
8,000
Quantity (tons/year)
P
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0
0
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/

t
o
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D
Private
MC
1.3
12,000
No Pollution Tax
Private
Equilibrium
Social
Optimum
After Tax
Equilibrium
Before Tax
Equilibrium
Social MC
XC
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Subsidizing a Positive
Externality
12
Quantity
(000s tons/year)
P
r
i
c
e

(
$

/

t
o
n
)
Private
Demand
MC
8
No Subsidy
XB
Social
Demand
14
10
16
Quantity
(000s tons/year)
P
r
i
c
e

(
$

/

t
o
n
)
Subsidy
Private
Demand
MC
Subsidized
Demand
Subsidy
12
8
14
10
16
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Tragedy of Commons
When use of a communally owned resource has
no price, the costs of using it are not considered
Use of the property will increase until MB = 0
This is known as the tragedy of the commons
Suppose 5 villagers own land suitable for grazing
Each can spend $100 for either a steer or a
government bond that pays 13%
Villagers know what everyone before them has done
Steer graze on the commons
Value of the steer in year 2 depends on herd size
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Payoff For a Steer
Using the information in the table below, each
villager makes a decision
The fourth is indifferent between the two assets
He buys a steer
The fifth buys a bond
# Steers Selling Price per Steer Income per Steer
1 126 26
2 119 19
3 116 16
4 113 13
5 111 11
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What the Villagers Did
The village has 4 steer feeding on the commons
for one year
At the end of the year, 4 steer sell for $113 each
Total revenue for the village is (5) (113) = $565
Outcome is the same as 5 bonds
They could have done better
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A Better Choice
# Steer
Selling
Price
Income per
steer
Total Cattle
Income
Marginal
Income
1 126 26 26 26
2 119 19 38 12
3 116 16 48 10
Net income from one bond after one year is $13
Buy a steer only if its marginal benefit is at least $13
First villager buys a steer and all others buy bonds
Total net income is 26 +(4) (13) =$78
A net gain of $13 compared to the first scenario of $65
Tragedy of the commons is the tendency for a resource that has
no price to be used until its marginal benefit is zero
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The Effect of Private Ownership
The villagers decide to auction off the rights to
the commons
Auction makes the highest bidder consider the
opportunity cost of grazing additional steer
Villagers can borrow and lend at 13%.
One steer is the optimal number
Winning bidder pays $100 for the right to use the
commons
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The Effect of Private Ownership
The winning bidder starts the year
Spends $100 in savings to buy a yearling steer
Borrows $100 at 13% to get control of commons
The winning bidder ends the year
Sells the steer for $126
Gets original $100 back
$13 opportunity cost of buying a steer
$13 interest on loan for the commons
Economic surplus of the village is
(4 x $13) + $26 = $78
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Information and Invisible Hand
Perfect competition assumes perfect information
where all parties have all relevant information
The outcome is socially efficient
Without free and perfect information, market
results are not efficient
In reality, information is imperfect and can only
be obtained with a cost via research or
middleman
Parties must decide how much information to
gather
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Consumer Choice: Buying
DSLR Camera
Best Denki recommends $1,200 Nikon D7100
DSLR camera
Sales rep seems knowledgeable
Your next move is
Thank them and do more research
Trust the sales rep and buy them
Go home and buy at the best price online ($950)
Sales representatives supply information to
buyers
Information makes markets more efficient
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Selling Product Online
Koh wants to sell a Win the War stamp.
His reservation price is $300
An ad in the local newspaper cost $5
eBay cost is 5% of the Internet auction price
The maximum price in the local market is $400
Two eBay shoppers have secret reservation prices
of $800 and $900, respectively
Rule of eBay is that the highest bidder secured the
product but pay the second highest price
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Selling Win the War stamp
Benefits of eBay
Card sells for $800 on eBay less $40 commission
Ellis nets $760, $460 above his reservation price
Buyer surplus is $100
Local option is inferior
Card sells for $400 less $5 cost of ad
Koh nets $395, $95 more than his reservation price
Buyer surplus is $0
Economic surplus is increased when a product
goes to the person who values it the most
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$
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Units of information
MB
The Optimal Amount of
Information
More information is better than less
Gathering information has a cost
Marginal benefit starts high, then falls rapidly
Low-Hanging Fruit Principle
Marginal cost starts low,
then increases
Optimal amount of
information is I* where
MC = MB
MC
I
*
Optimal
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Free Rider Problem
A free-rider problem exists when non-payers
cannot be excluded from consuming a good
Interferes with incentives
Market quantity is below social optimum
Stores bear the cost of training sales reps on
merchandise
Shoppers use sales reps as information source
Then some shoppers buy elsewhere
Store is unable to capture some of the value it
delivered to the shopper: a free-rider problem
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Rational Search Guidelines
Additional search time is more likely to be
worthwhile for expensive items than cheap ones
Apartment search in Taipei, Tawian involves less
time than Tokyo, J apan
Taipei has lower rents and narrower price range
Prices paid will be higher when the cost of a
search is higher
Two buyers of piano, only one with a car
Buyer with the car will look at more pianos before
buying
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Gamble Inherent in Search
Additional search has costs that are certain
Benefits are uncertain benefits
Additional search has elements of a gamble
A gamble has a number of possible outcomes
Each outcome has a probability that it will occur
The expected value of a gamble is the sum of
(the possible outcomes times their respective
probability)
A fair gamble has an expected value of zero
A better-than-fair gamble has a positive expected
value
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Risk Preferences
A risk-neutral person would accept any gamble
that is fair or better-than-fair
A risk-averse person would refuse any fair
gamble
A risk-seeking person would accept any
gamble that is less than fair
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The Gamble in the Search
You need a one-month sublet in Hong Kong
One type of apartment rents for $400 and it is 80%
of the available market
The other type rents for $360 and makes up 20% of
the market
You must visit the apartment to get the rental rate
Cost per visit is $6
You are risk-neutral
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Hong Kong Apartment Search
The first apartment you visit is the $400 version
Try the next apartment if the gamble is at least fair
Two outcomes to the gamble
You find a lower-priced apartment and your net benefit is
$34 with 20% probability
You find another $400 apartment and your net benefit is
$6 with 80% probability
Expected value of the gamble is
($34) (0.20) +( $6) (0.80) =$2
Gamble is more than fair. Accept the gamble and
keep searching
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Commitment Problems and Search
Some searches are for circumstances requiring
commitment over some period of time
Leasing an apartment or Taking a job
Contracts are used to bind parties together and may
carry penalties for breaking the arrangement
Search is costly and therefore limited
People end their searches when the marginal cost of
searching exceeds the marginal benefit
One party may rationally choose to terminate the
agreement and pay the penalties if better option
arises
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Asymmetric Information
Asymmetric information occurs when either the
buyer or seller Is better informed about the
goods in the market
Mutually beneficial trades
may not occur
The party with the additional
information may use to gain
at the expense of the other
party
Buyer Seller
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Private Sale of a Used Car
Akari's used car is in excellent condition
Akari reservation price is $10,000
Normal used car value is $8,000
Haruto wants to buy a used car
His reservation price is $13,000 for one in excellent
condition and $9,000 for one in average condition
Determining the condition of Akari's car has a cost
and the results are uncertain
Haruto cannot verify that Akari's car is superior
Haruto buys another used car for $8,000; Akari's
is unsold
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Surplus Loss and Asymmetric
Information
If Haruto can be convinced that Akaris car is
good, they can negotiate and agree at $11,000
Buying a normal car, Haruto's loss is $1,000
Pays $8,000 and has a gain of $1,000
Harutos loss from buying an average car instead of
Akari's = $13,000 $11,000 = $2,000
Haruto's net loss is $1,000
Akaris loss from losing Haruto as a customer is
$1,000
Total loss is $2,000
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The Lemons Model
People who have below average cars (lemons),
are more likely to want to sell them
Buyers know that below average cars are likely to
be on the market and lower their reservation prices
Good quality cars (jewels) are withdrawn from
the market
Average quality decreases further and reservation
prices decrease again
The lemons model says that asymmetric
information tends to reduce the average quality
of goods for sale
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Naive Buyer
Two kinds of cars: good cars and lemons
Owners know what kind they have
Buyers can't determine a car's quality
Buyers are risk neutral
Buyer offer the expected value for a used car:
(0.90)($10,000)+(0.10)($6,000) = $9,600
Good car owner refuse to sell. Bad car owners
keen to sell. The buyer will get a lemon
Good Cars Lemons
Probability 90% 10%
Value $10,000 $6,000
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Credibility Problem
Parties gain if they find a way to communicate
information truthfully
If Akari can convince Haruto her car is in
excellent condition, Haruto will buy
Statements are not credible
Akari offers Haruto a six-month warranty on all car
defects at the time of purchase
A warranty for a lemon would cost more than the
economic surplus gained
Only sellers of good quality cars would offer the
warranty
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The Costly-to-Fake Principle
To communicate information credibly, a signal
must be costly or difficult to fake
Sellers have an incentive to exaggerate the quality
of their product
Buyers value objective information about quality
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Costly Signals
Television advertising is expensive
Signals a company's commitment to its product and
a potential signal of quality
Educational institutions' brands and students'
grades signal quality
A
+
student from prestige institution more likely to be
offered a job than C student from average institution
Conspicuous Consumption
Consume branded goods cars signal success
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Statistical Discrimination
Statistical discrimination uses group
characteristics to infer individual characteristics
Example
Women in late twenties tend to have babies - High
cost in employment
Younger male drivers more likely to involve in car
accident Charge a higher insurance premium
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Adverse Selection
Adverse selection occurs because insurance
tends to be purchased more by those who are
most costly for companies to insure
Insurance is most valuable to those with many
claims
Adverse selection increases insurance
premiums
Reduces attractiveness of insurance to low-risk
customers
"Best" insurance risk customers opt out
Rates increase and drive out good customers
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Moral Hazard
Moral hazard is the tendency of people to expend
less effort protecting insured goods
People take more risk with insured goods or activities
Deductibles give policy holders an incentive to be
more cautious
Use co-payment to reduce moral hazard
Suppose a car owner has a $1,000 deductible
policy
The owner pays the first $1,000 of each claim
Strong incentive to avoid accidents
Claims less than $1,000 are not reported
Insurance premiums go down
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