Cyberlecture

This chapter introduces you to the third party effect of external costs and external benefits. You will learn that externalities cause an inefficient allocation of resources, but with negotiation between the affected parties solutions can be devised to correct the misallocation.

What is an externality?
An externality is a benefit or a cost of an activity received by people other than those who pursue the activity.

• a third party gains from an external benefit
• a third party is harmed by an external cost

In a market for a good or service, external costs or benefits are not taken into account by demanders and suppliers. Therefore cost and benefit are both underrepresented by market demand and supply, and resources are not allocated efficiently.

• in a market with external costs, price is too low and output is too high
• in a market with external benefits, price and output are both too low

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Practice Activity 1 Try answering some questions about external benefits and equilibrium.

What is the Coase Theorem?
The Coase Theorem says that people can always arrive at an efficient solution to the problem of externalities if they can negotiate the solution at no cost.

• people will look for a solution that maximizes total economic surplus
• if there is a negotiating cost, it must be less than the total economic surplus

Read about Nobel Laureate Ronald Coase – his life and his work – at the Nobel e-Museum (http://www.nobel.se/economics/laureates/1991/index.html).

Where negotiation will not solve the problem of externalities, the government often passes laws to control external costs.

• traffic lights
• speed limits
• building restrictions

The government sometimes subsidizes operations that produce external benefits.

• flu shots
• tree planting
• museums

What are property rights?
Property rights are conferred on the owner of a property. The owner has the right to do anything legal with that piece of property, including excluding others from using it.
      The tragedy of the commons reflects that when a resource has no price – usually when the resource is not privately owned – it will be used until its marginal benefit falls to zero.

• everyone is allowed to use the resource at no price
• individuals consider only their own personal costs and benefits
• common property: air, oceans, parks

Practice Activity 2 Try answering some questions about the socially optimal use of the commons.

It is not practical to devise laws to control the use of all common property. If the costs of devising and enforcing a law exceed the benefits, the law should not be passed.

Find out how the tragedy of the commons played out in the Grand Banks cod fishery over the 20th century at Mount Allison University's Canadian Heritage Site (http://www.mta.ca/faculty/arts/canadian_studies/english/about/fisheries/index.htm#sustainability). Discover why Newfoundland fishers are now largely unable to make a living fishing the once bountiful cod.

Economic Naturalist When I set out to do a presentation in class, the computer projection equipment often does not work. Why?

What are positional externalities?
Positional externalities occur when a person takes an action to improve her relative position that will reduce the expected reward of another person. For example, an individual athlete may take steroids to become stronger than his competitors, making his rewards greater and the competitor's rewards less.
      A positional arms race occurs when competitors make mutually offsetting investments to take first place in their race for the top.

• results in a socially inefficient use of resources
  • people spend too much on performance enhancement

Positional arms control agreements attempt to limit mutually offsetting investments in performance enhancement. If all contestants continue to increase investments, no one's relative position will improve.

• campaign spending limits
• arbitration agreements

Understanding Questions Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.