Property Rights, Efficient Market

Allocation and Externality

Lecture Note 3

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 What is property right?
• The manner in which producers and consumers use environmental resources
depends on the property rights governing those resources.

• Property right refers to a bundle of entitlements defining the owner’s rights,

privileges, and limitations for use of the resource.

• Property rights can be vested either

• with individuals, as in a capitalist economy, or
• with the state, as in a socialist economy.

Private property rights are fundamental preconditions for the existence of market
economies.
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 Characteristics of well-defined property right
• Universality – all resources are assumed to be privately owned and all entitlements well-
defined. There is no confusion over who owns what.

• Exclusivity – All benefits and costs accrued as a result of owning and using the resources
should accrue to the owner, and only to the owner, either directly or indirectly by sale to
others. There are no spill over effects on others.

• Transferability – resources are freely transferable from one owner to another in a voluntary
exchange.

• Enforceability – resources are secured from involuntary seizure or encroachment by others.

In reality, there is no property rights system can satisfy all four of these criteria perfectly.
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• An owner of a resource with a well-defined property right has a powerful incentive to use
that resource efficiently because a decline in the value of that resource represents a
personal loss.
• E.g. Farmers who own the land have an incentive to fertilize and irrigate it because the resulting
increased production raises income.
• Similarly, they have an incentive to rotate crops when that raises the productivity of their land.

• When well-defined property rights are exchanged, as in a market economy, this exchange
facilitates efficiency.

• Because the seller has the right to prevent the consumer from consuming the product in the
absence of payment, the consumer must pay to receive the product.

• Given a market price, the consumer decides how much to purchase by choosing that
amount which maximizes his or her individual net benefit.

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• The consumer’s net benefit is the area under the demand curve minus the area representing the cost. The cost to the
consumer is the area under the price line, since that area represents the expenditure on the commodity. Obviously, for a given
price Po, consumer net benefit is maximized by choosing to purchase Qo units.
• The area A is the geometric representation of the net benefit received, known as consumer surplus.
• The seller faces a similar choice. Given price Po, the seller maximizes his or her own net benefits by choosing to sell Qo
units. The net benefit received (area B) by the seller is called producer surplus.
• The price level which producers and consumers face will adjust until supply equals demand.
Supply = demand
• Given that price, consumers maximize the surplus, producers maximize their surplus, and the market clears.
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 Private, External and Social Costs/Benefits
• Private cost is the cost to an individual person, or a firm, of the resource(s) used,
measured at market prices.
• Private costs are the costs borne by those who are directly involved in the decision to consume or
produce a product.
• The private costs of driving a car include the fuel and oil, maintenance, depreciation, and even the drive
time experienced by the operator of the car.
• Private benefit is the benefit received by those directly involved in the consumption and
production of a product.

• External costs are directly associated with producing or delivering a good or service, but
they are costs that are not paid directly by the producer.
• When firms produce products and households consume them, they often affect other people.
• For example, someone smoking in a factory may harm the health of other workers and a clothing firm,
that dumps waste into a river, may damage the fishing stocks of a fish farmer and harm the environment.

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• External benefit is a benefit that someone gains because of someone else's action, outside
of any market transaction between them. E.g. Immunizations.

• Social costs are the total costs of an economic activity to society.

• Social costs include both the private costs and any other external costs to society arising from the
production or consumption of a good or service.
• When social costs exceed private costs, there are external costs involved.
• Social costs will differ from private costs, for example, if a producer can avoid the cost of
air pollution control equipment allowing the firm's production to impose costs (health or
environmental degradation) on other parties that are adversely affected by the air pollution.

• The social costs include all these private costs (fuel, oil, maintenance, insurance,
depreciation, and operator's driving time) and also the cost experienced by people other
than the operator who are exposed to the congestion and air pollution resulting from the
use of the car.

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 Social cost = Private cost + External cost

• If external costs > 0, then private costs < social costs.

• Then society tends to:
- Price the good or service too low, and
- Produces or consumes too much of the good or service.

• Social benefits are the total benefits to the society, arising from an economic activity.

• They include both private and external benefits. Again, where social benefits are greater
than private benefits, external benefits exist.

Social benefit = Private benefit + External benefit

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• A socially efficient output rate in a competitive market is reached when social costs (both
private and external costs) are considered in production and consumption decisions.

• When significant external costs are associated with a good (or service), then the price of
the good is too low (because external costs are not being paid) and its output level is too
high, relative to the socially efficient rate of output for the good. The bottom line, unless
costs and prices include external costs, the market will not produce a socially efficient
result.

• Consider also the competitive issues: At the individual firm level, as well as across states
or nations, failure to pay for external costs would provide those firms or nations with a
competitive advantage over producers who are paying the external costs associated with
the production of their products.

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 Externality
• An externality exists whenever the welfare of some agent, either a firm or
household, depends not only on his or her activities, but also on activities
under the control of some other agent.

• Externalities are unintentional side effects of an activity affecting people other

than those directly involved in the activity.

• There are 2 types of externality:

• Negative externality
• Positive externality

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• Negative externality arises when an action by an individual or group produce harmful effects on
others.

• A negative externality is one that creates side effects that could be harmful to either the general
public directly or through the environment.

• An example would be a factory that pollutes as a result of its production process.

• This pollution may pose health risks for nearby residents or degrade the quality of the air or water.

• Either way, the owner of the factory does not directly pay the additional cost to address any health
issues or to help maintain the cleanliness of the air or water.

• In some cases, however, the harmed parties can use legal measures to receive compensation for
damages.

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• The conclusions about market allocations of commodities causing negative externalities
are:
• The output of the commodity is too large
• Too much pollution is produced
• The prices of products responsible for pollution are too low
• As long as the costs are external, no incentives to search for ways to yield less pollution per unit of
output are introduced by the market
• Recycling and reuse of the polluting substances are discouraged since release into the environment is so
inefficiently cheap.

• A positive externality, on the other hand, is an unpaid benefit that extends beyond those
directly initiating the activity.

• It arises when an action by an individual or a group confers benefits to others.

• E.g. A technological spill over is a positive externality and it occurs when a firm's invention not only
benefits the firm but also enters into the society's pool of technological knowledge and benefits the
society as a whole.

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• Another example would be a neighbourhood resident who creates a private garden, the aesthetic
beauty of which benefits other people in the community.

• Also, when a group voluntarily chooses to create a benefit, such as a community park, others may
benefit without contributing to the project.

• Any individuals or groups that gain additional benefits without contributing are known as "free
riders".
• Free rider – An individual who does not pay for the goods or services he or she consumes.

• A market failure involves either a failure of property rights, or a violation of one or more
assumptions of the perfect market model.

• Market failure exists when a free market does not allocate resources efficiently.

• Both negative and positive externalities are considered to be forms of market failure.
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 Private, Public and Common/Open Access Resources
• Private resource is one that exhibits consumptive divisibility and consumptive excludability.
Example of private resource?
• Consumptive divisibility means when one uses a resource less or nothing is left for the next user.
• Consumptive indivisibility means when one uses a resource the same quantity is left for the next user.
• Consumptive excludability mean one is prevented/restricted from using the resource.
• Consumptive nonexcludability mean no one is prevented/restricted from using the resource. even those who
fail to pay for it cannot be excluded from enjoying the benefits it confers.

• Public resource is one that exhibits both consumption indivisibilities and nonexcludability.
• E.g. air, knowledge, TV reception, radio wave, national defence, highway and sunlight.

• Common/Open access resource is one that exhibits consumptive divisibility and consumptive
nonexcludability. One must concerned that they are not overused. This is known as the
Tragedy of the Commons problem:
• All biological resources such as forest products and fisheries are example of open access resource.
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 THE PURSUIT OF EFFICIENCY (I)
• Private Resolution Through Negotiation
• The simplest means to restore efficiency occurs when the affected parties are small, making negotiation
possible. Suppose, for example, the noise of a stereo system shatters the tranquility of an evening.
• This situation is an environmental problem because the stereo owner does not exclusively bear all the
costs of his/her actions. The neighbour could bribe the stereo owner to reduce the volume of the stereo
by paying an amount per decibel reduced to the owner.

• The Courts: Property Rule And Liability Rules

• Here a court system can respond to environmental conflicts by imposing either property rule or liability
rule.

• Property rules specify the initial allocation of the entitlement. The entitlements at conflicts for example
are, on one hand, the right to play a stereo loudly and, on the other, the right to peace and quiet.
• The court merely decides which right is preeminent (much more important) and places an injunction
against violating that right.

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 THE PURSUIT OF EFFICIENCY (II)
• The injunction is removed only upon obtaining the consent of the party whose right was violated.
Consent is usually obtained in return for an out-of-court monetary settlement.

• When individual negotiation is not practical for one reason or another, the courts can turn to liability
rule.

• Liability rules are rules, which award monetary damages, after the fact, to the injury party. The amount
of the award is design to correspond to the amount of damage inflicted.

• Legislative And Executive Regulation

• Here, the legislature could dictate that no one should play his or her stereo louder or beyond a given
decibel. This dictum (formal statement) might be backed up with sufficiently large jail or fines to deter
potential violators. Alternatively, the legislature could impose a tax on decibels.

As a dog returns to its vomit, so a fool returns to his folly (Pro 26:11). Don’t be the dog, don’t be the fool. Think God, think
environment.
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Source: http://www.picturequotes.com/churches-are-like-announcement-factories-that-pump-toxic-levels-of-noise-pollution-into-the-quote-355641

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