Topic 12 - Externalities, Common Pool Resources and Property Rights

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Externalities, Common Pool Resources And Property Rights

Externalities And Resource Allocation


Externalities refer to the external costs or benefits of an activity, i.e. costs or benefits that affect a third party. The effects of externalities can be summed as follows:

Individuals that consider only their own costs and benefits will engage too much in activities that cause negative externalities and too little in those that generate positive externalities

Thus, when externalities exist, the pursuit of self interests will not result in socially optimal quantities.

Other Externalities Include:[2]

  1. Irrelevant Externalities - are effects on the welfare of people other than those directly involved in a transaction that occurs via changes in relative prices
    • This is referring to the effects of the 'invisible hand and its allocative function'
    • These externalities are 'irrelevant'
    • Inframarginal Externalities - the marginal consumer experiences no benefits or loss
  2. Positional Externalities - a change in 1 persons performance changes the expected reward of another person in situations in which rewards are dependent upon relative performance
    • Positional Arms Race - series of mutually offsetting investments in performance enhancement that is stimulated by a positional externality
      • Positional Arms Race Agreement - Limit mutually offsetting investments in performance enhancing. Can also be social norms e.g. “NERD!”


Coase Theorem

The Coase Theorem states that individuals will arrive at the efficient level of production if, and only if:

  1. Property rights are established and trade-able
  2. Negotiation is costless
  3. Small number of involved parties

Regardless of who owns the property rights, the efficient outcome can be reached with communication. However the property rights decide who must pay.

Coase Theorem Examples


In this example, Ruth is dumping unfiltered toxins into Hugh's environment. Ruth's marginal cost to install the filter is 30 (difference between gains Without Filter and With Filter) whilst, Hugh incurs a marginal benefit of 50 if the filter is installed. It is clear that the efficient situation in this case is "With Filter" as it has 200 of economic surplus compared to 180 surplus in "Without Filter". In this case Ruth has the right to dump unfiltered toxins.

  1. Option 1 - If there is no communication, Ruth will continue to dump unfiltered waste in pursuit of her self interest causing an inefficient situation.
  2. Option 2 - If there is communication at no cost, Hugh will pay up to $50 (his marginal benefit), while Ruth will accept no lower than $30 (her marginal cost) to filter the water. This means Hugh will pay Ruth somewhere between 30 and 50 dollars to install a filter and an efficient situation will be reached.


In this next example, it is assumed Ruth needs Hugh's permissions to dump toxins. In this case Ruth's marginal benefits is $50 (i.e. the value of dumping toxins (unfiltered) is worth $50 to her), Hugh's marginal cost of switching from "With Filter" to "Without Filter" is $30. Since the marginal benefits are greater than marginal costs, it is clear the efficient situation is a switch to "Without Filter" as economic surplus ($220) is higher than the economic surplus ($200) "With a Filter".

  1. Ruth will pay up to $50 to switch to Without Filter and Hugh will accept no less than $30 to change to the "Without Filter" situation. Ruth will pay somewhere between 30 and 50 dollars to dump unfiltered toxins


Legal Remedies for Externalities

Since negotiations are not always practical, we need other remedies for externalities. We can use:

  1. Direct Regulation or,
  2. Market Based Instruments (MBI's) - Price or Quantity Based

Legal Remedies in Action - Example



Direct Regulation

If the aim was to reduce to 4 tonnes, (2 tonnes for each producer) the total cost will be 100 + 500 = 600 (Firm X) + 320 + 60 = $980.

  • $580 marginal cost from changing from 4tonnes to 2 tonnes for each firm

Price Based MBI's

  • Pigouvian Taxes are taxes used to control externality problems
    • Benefits - pollution is reduced by those firms who can do it at the lowest cost
  • Cost - requires detailed knowledge about the costs of reducing pollution

If we were to set a $101 tax per tonne of pollution, the marginal benefit for each firm from lowering pollution 1 tonne is $101.

  1. Firm X - will reduce from 4 tonnes to 3 tonnes (to gain $101 - $100 = $1)
    • Will not go to 2 tonnes as it costs them another $400 while they only receive a benefit of $101
  2. Firm Y - will reduce from 4 tonnes to 1 tonne. The $101 is greater than the cost associated with reducing pollution up until and including 1 tonne /day.
    • Moving from 1 tonne to 0 tonnes costs $220, and the benefits is only $101 so the firm will not do this.

In this case, the total cost to society is 200 (Firm X) + 480 (Firm Y) = $680, less than the $980 cost caused by direct regulation. This means a more efficient outcome is reach as the costs of reducing pollution are less.

Quantity Based MBI's - Trade-able Permits

For this form of remedy to be used, a market for the right to produce an externality needs to be established in the following way:

  1. Set Quantity Cap
  2. Define Property Rights and Distribute Them
  3. Set Up A Market to Allow The Trade of Permits

(it is similar to an auction system)

  1. Firm X - will pay up to $1000 for its 1st permit, $700 for its 2nd, 400 for its 3rd and 100 for its 4th
  2. Firm Y will pay $220 for its 1st, $100 for its 2nd, $60 for its 3rd and 20 for its 4th.

If there were 4 permits to be bought/sold (to ensure total pollution was 4 tonnes), Firm X will outbid Firm Y for the 1st 3 permits as its marginal benefits (reduction in costs) are 1000, 700, 400 and Firm Y's is 220. Firm Y will buy the fourth permit as its gain ($220 is greater than the $100 Firm X would get from the permit). At the end of the day, Firm X will produce 3 tonnes of pollution whilst Firm Y will produce 1 tonne and the permits will trade between $100 (the next highest marginal benefit from another permit) and $220 (the most Firm Y would pay for the fourth permit - its marginal benefit).

This method would reach an efficient situation as the total costs to society are $680 (the exact same as the price based MBI), $300 less than direct regulation If there were any costs in purchasing the permits, this would not effect the total cost to society but only the cost to the firms as the revenues raised from sales of the permits (e.g. by the government) would equal the costs of purchasing the permits.

Taxes Vs. Permits


  • Taxes – if we know the social marginal cost of the externality
  • Permits – if we know the optimal level of the externality

Property Rights, Common Pool Resources And Open Access

Common Resources are non excludable but rival resources, for example fish in the ocean. There is a tendency for common resources to be used until the marginal benefits of the resource are = 0. This is referred to as the Tragedy of the Commons. This is because the resource is open to every one (open access), 1st come 1st served and the opportunity cost of using the resources is not accounted for (the next user receives all the benefits of being an additional user, but the costs are shared by the group - similar to a negative externality). Ultimately, this leads to over exploitation of the resource.


In this example [5] the tragedy of the commons is clear for all to see. The marginal cost is $13 (13% bond) and the price of a cow is $100.

Individually, 4 people will choose to buy cows (assuming indifference between buying a cow or bonds) leaving the village with $65 of income (4 x $13 + $13).

  • This is because the individuals ignore the fact that additional cows reduce the value of other cows - imposes an external cost on others
    • Smart for 1 dumb for the group

As a group (if they worked together), 1 person will buy a cow and the rest will buy bonds. Village income would be $26 + 4 x $13 = $78.

  • This is because the marginal benefit from the 2nd cow is $12 (2 x $19 - $26) but the marginal cost is $13, so by buying more than 1 cow the group destroys income.

If property rights were established, the $78 could be achievable, since the right to use the land to the exclusion of all others produces an economic profit of $13 ($26- 13), and you can borrow at 13%, you would be willing to pay up to $100 ($13 interest cost) to purchase the right to use the land. Thus only 1 cow would be on the paddock and village income of $78 would be achieved - efficient outcome.

However, this is extremely difficult to do in reality, as it is almost impossible to manage common resources on a global scale because of different jurisdictions and free riding.


  1. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  2. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  3. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  4. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  5. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
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