HE9091

Principles of Economics
Lecture 5
Externalities, Property Rights
and Economics of
Information
Tan Khay Boon
Email: khayboon@ntu.edu.sg
 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: FBAH or FBL, chapters 10 & 11
 External Costs and Benefits
• An externality is the name given to an external
cost or external benefit of an activity
• 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 external benefit is a benefit of an activity
received by people other than those who pursue
the activity
– Also called a positive externality
Externalities Affect Resource
Allocation
• Externalities reduce economic efficiency
– Need to rectify the externalities for the market to be
efficient
– Possible to rectify externality by private parties –
Coase Theorem
– When private efficient solutions to externalities are
not possible, government intervention or other
collective action may be used
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
• Phoebe harvest bees until the Private costs (MC)
are equal to private benefits (MB)
•  Market equilibrium
• Social benefits are greater than private benefits
When external benefits exist,
market equilibrium produces less
than the social optimum
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 (MC) are equal to private benefits (MB)
•  Market equilibrium
• Social costs are greater than private costs

When external costs exist,

market equilibrium produces more
than the social optimum
 External Costs
No External Cost External Cost
Price ($000s / ton)

Social MC

Price ($000s / ton)

Private
2.3 $1,000/ton
MC 2.0
1.3 Private
1.3 MC
D
12,000 D
Quantity (tons/year)
8,000 12,000
Quantity (tons/year)

Deadweight loss from Social Private

pollution = $2 M/yr Optimum Equilibrium
 Positive Externality for
Consumers
Deadweight loss from
positive externality
XB
MBPVT + XB
MC
Price

MBSOC
MBPVT
Social
Demand

Private Demand
QPVT QSOC
Private Social
Equilibrium Quantity Optimum
Effects of Externalities

With externalities,
private market outcomes
do not achieve
the largest possible economic surplus

Cash is left on the table

Market Failure
 Remedying Externalities
• With externalities, private market outcomes do
not achieve the largest possible economic
surplus
• Possible to implement actions to capture the
extra surplus from the market outcomes
 Abercrombie the Polluter –
Scenario 1
• Abercrombie’s 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 only benefits Fitch
• Parties do not communicate
 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
 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

 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
 Abercrombie the Polluter –
Scenario 3
• Abercrombie’s 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

 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

Laws Can Change the Outcome
• Suppose the law makes polluters liable for the
cost of cleaning up their pollution
– Polluters need to compensate non-polluters and get
lower incomes
– Non-polluters get higher incomes after compensation

With Filter Without Filter

Abercrombie's Gains $100 / day $150 / day

Fitch's Gains $100 / day $70 / day

Total Gains $200 / day $220 / day

 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
 Benefits and Costs of Shared
Living
 Live together if the benefits exceed the costs

$800 per month $600 per month $200 per month

Total Cost of Separate Total Cost of Rent Savings
Apartments Shared Apartment from Sharing

Ann's Cost of Betty's Cost of

Least-Cost
Problem Solving the Solving the
Solution
Problem Problem
Ann pays Betty
Ann's phone Pay Ann $250 to Pay Betty $150
$150 per
usage decrease usage to tolerate Ann
month
 Net Benefit of Shared Living

Cost of Phone
Rent Savings Gain in Surplus
Accommodation
$200 per month $150 per month $50 per month

• Ann and Betty will live together

(but how to split the rent? As unfair to betty if she pays equal rent but not use the phone)
 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 (ie betty willing to pay
max rent of $250 if she gives up phone)

• 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
 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
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
Optimal Amount of Negative
Externalities
MC & MB
MC

MC = MB Optimal amount
of pollution

MB

Q
Quantity of Pollution
 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
 Taxing a Negative Externality
No Pollution Tax Pollution Tax
$1,000 / ton
Social MC Private MC + Tax

Price ($000s / ton)

Price ($000s / ton)

2.3 XC Tax
2.0 2.0
Private Private MC
1.3 MC 1.3

D D

8,000 12,000 8,000 12,000

Quantity (tons/year) Quantity (tons/year)

Social Private After Tax Before Tax

Optimum Equilibrium Equilibrium Equilibrium
 Subsidizing a Positive
Externality
No Subsidy Subsidy

MC Subsidy MC

Price ($ / ton)
Price ($ / ton)

XB
14 14
10 10
Social Subsidized
8 8
Demand Demand
Private Private
Demand Demand
12 16 12 16
Quantity Quantity
(000s tons/year) (000s tons/year)
 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
 Payoff For a Steer
• Using the information in the table below, each
villager makes a decision

# Steers Selling Price per Steer Income per Steer

1 126 26
2 119 19
3 116 16
4 113 13
5 111 11
• The fourth is indifferent between the two assets
– He buys a steer
• The fifth buys a bond
 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

 A Better Choice
Selling Income per Total Cattle Marginal
# Steer
Price steer Income 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
 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
 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
 Selling Product Online
• Koh wants to sell a 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
 Selling Win the War stamp
• Benefits of eBay
– Stamp sells for $800 on eBay less $40 commission
– Koh nets $760, $460 above his reservation price
– Buyer surplus is $100
• Local option is inferior
– Stamp 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
 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
Optimal
• Marginal cost starts low,
MC
then increases
• Optimal amount of

$/unit
information is I* where MB

MC = MB I*
Units of information
 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
 Rational Search Guidelines
• Additional search time is more likely to be
worthwhile for expensive items than cheap ones
– Apartment search in Taipei involves less time than
Tokyo
• 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, likely to pay lower price for piano
• Buyer without car has higher search cost, likely to
search less and pay more for the piano.
 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
 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
 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
 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
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
 Asymmetric Information
• Asymmetric information occurs when either the
buyer or seller Is better informed about the
goods in the market
– Mutually beneficial trades
Buyer Seller
may not occur
Fact A
– The party with the additional
Fact B
information may use to gain
Fact 1 Fact C
at the expense of the other Fact 2 Fact D
party
 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
 Surplus Loss and Asymmetric
Information
• If Haruto can be convinced that Akari’s 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
– Haruto’s loss from buying an average car instead of
Akari's = $13,000 – $11,000 = $2,000
– Haruto's net loss is $1,000
• Akari’s “loss” from losing Haruto as a customer
is $1,000
• Total loss is $2,000
 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
 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

Good Cars Lemons

Probability 90% 10%
Value $10,000 $6,000

• 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
 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
 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
 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 and cars signal success
 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
 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
 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