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Gary Galles,
To contrast private‑ and common property rights (leading to the common pool problem), I use the following illustration.
I ask my
students when fishermen go fishing. They reply that fishermen arise at some
"ungodly" hour, so they can be fishing at or before dawn. I then ask
my students why this is so: Is it because fishermen like wading hip deep in
cold water in the dark? Is it because all fishermen are insomniacs? Some
students will come up with "That's when the fish are biting." I focus
in on that answer, and ask whether fish only eat in the morning, or if there
might be some other reason. As a hint, I ask them who owns the fish. They
quickly see that usually in the
I then ask whether assigning private fishing rights might be socially beneficial. It can benefit the resource owner by generating a return stream. It can also benefit fishermen, by allowing them to pay more dollars in exchange for more enjoyable fishing at a lower cost in terms of sleep lost. I show how common rights to the fish may deplete the size of the run and even threaten the species with extinction, whereas if someone owned the fishing rights he would adopt a "harvesting" strategy that would maximize the present value of those rights and perhaps save the fish.
I go on to talk about such common pool resource examples as whales, clams on public beaches, the buffalo, Indian property rights in beavers, pollution, etc., to emphasize the central aspect property rights play in the allocation of resources and the troubles that can arise from a lack of established property rights. I emphasize that since markets work well (with all their beneficial information and incentive functions) only when rights are clear, this forms a basis for a necessary role of a government in a market economy: the definition and enforcement of property rights.
Thomas M. Love,
When we were children, the adults in our lives went to considerable lengths to impress upon us the value of saintly behavior. Everyone received a very clear message: the ideal amount of sin was zero! We were all expected to strive to live up to this standard.
I like to tell my students that this approach to sin is seriously flawed. Our ministers and parents did make it clear that sinning has costs. The expected costs of sin are in the form of guilt, punishment, penance and possible eternal damnation. But it is equally apparent to anyone who has contemplated the act that benefits also accompany sinning. We can expect that sin will occur when the expected benefits of sinning are larger than the expected costs. From this perspective it follows that the ideal amount of sin is not zero.
This account will have to be corrected to allow for the external costs of sin, but that is beside the point. The point is that students are now hooked! They will be listening intently as you lead them into cost‑benefit analysis, external costs and benefits, marginalism, e.g., the marginal benefits of the next sin, or present value, e.g., the present value of eternal damnation. Instructors can add their own touch to the story with reference to personal experiences.
Pollution and Production Possibilities
John P. Cochran,
Many students believe that pollution be should be reduced to zero. The opportunity cost concept and the production possibility frontier can be used to dispel this fallacy. Draw a PPF with GDP on the horizontal axis and reduction of pollution on the vertical axis. The students should quickly see that reduced output is an opportunity cost of pollution and with current technology zero pollution would probably entail zero output.
Returns to Scale and Externalities
Masoud Moghaddam,
Students are often confused between returns to scale and externalities. The former follows from the shape of the average costs curve, while the latter is a determinant of the slope of the long‑run supply curve of a perfectly competitive industry. I shed more light on these two issues by presenting a simple example in which there are two producers, A and B, whose firms are very close to one another. A produces honey, while B grows flowers. As such, firm B has positive externalities upon the production of firm A, simply because bees travel back and forth at no charge. Firm A produces more honey just because it is built close to firm B, and honey is plentiful at a lower per‑unit price. It is very helpful if two simple demand and supply diagrams are drawn for each firm, and actually show how the supply of honey shifts to the right due to the flowers being close by. There are several points to be made here.
1. Externalities are not marketable, i.e., firm B cannot charge firm A for each bee's consumption of flowers.
2. Externalities, as the name implies, are external to firm A, whereas returns to scale are purely an internal phenomenon, i.e., it's solely determined by firm A's efficiency, access to inputs, and the like.
3. As long as externalities are not internalized, then there is no direct relation between externalities and returns to scale.
4. Internalization is possible if either of the two producers decides to buy up the neighboring firms. As soon as externalities are internalized, then it is possible to relate them to returns to scale.
5. Positive externalities create social benefits, in that there is more honey available on the market.
Negative externalities, along with their social costs, can easily be explained in the context of the same example. Furthermore, the case of negative externalities is even more interesting, because it requires some form of government intervention. Most notably, the government can internalize negative externalities by taxation, or can force one firm to take the other one over, and thus maximize the joint profits of both firms. Margin benefit/marginal cost analysis from the society's point of view can also be applied to the two previously drawn diagrams.
Harold Hotelling,
A diagram familiar in the study of external costs and property rights can easily be adapted to the study of a particular type of pollution, viz. crime. Just as the costs of pollution (Ca) and of cleaning up (Cb) can be traded off, with the optimum being the minimum point on the total-cost curve, the costs of crime and of fighting crime can be compared to suggest an optimum crime-deterrence budget. The horizontal axis, in both cases, represents control, where 0% is complete deterrence and 100% the level in the absence of any deterrence.
A more extended adaptation changes the variables somewhat and addresses the Type I and Type II errors possible in a criminal trial. No Ca represents the cost of releasing guilty individuals, including their further crimes. Cb represents the cost of punishing innocent defendants. The horizontal axis is now a measure of the protections afforded those accused of crime. Once again, the optimum point is that at which the total of the two costs is minimized, and where MCa and MCb are equal and opposite (NOT, except by coincidence, the point of intersection). Thus the cost-benefit equality at the margin works even in such areas as criminal law where many students (and lawyers) think in terms of absolute rules, i.e., vertical demand curves. The student will see why the standard of proof in criminal cases is proof beyond a "reasonable" doubt, not proof beyond any doubt. Such choices as the right to counsel and the exclusionary rule represent movements (here leftward) along the axis in the hope of lowering the total cost.
For homework, the student can be asked how the diagram changes under dictatorship (Ca is perceived as much lower and the minimum TC is further to the right) or civil lawsuits (the standard of proof is only be a preponderance of the evidence, again moving the minimum TC to the right).
Figure 34-1
Noise Ordinances and the Coase Theorem
Stuart E. Thiel,
This method makes the Coase Theorem accessible to principles courses by placing it in the context of MB = MC.
Situation: Greeks (i.e., fraternities, sororities) like loud, late parties; their neighbors do not. Assume one Greek house and one neighbor, who can negotiate costlessly, and assume that a local noise ordinance governs who has the right to the externality.
Draw on a blank transparency slide
axes labeled decibels (dB) and $. Run
the horizontal scale from 0 to 100 dB (F-14 takeoff), or 140 dB (pain
threshold). Suppose the noise ordinance
prohibits any noise over 50 dB (loud office) after
Now, suppose the noise ordinance is repealed, so the Greeks can make all the noise they like and the neighbor must pay the Greeks for additional silence. Turn the transparency over. The Greeks' MB for noise is now their MC for silence; ditto (MB of silence is now MC of noise.) for the neighbor. And we see Coase's result: the noise ordinance is irrelevant to the level of noise; the optimum remains where MC = MB. What changes is who pays whom, and how much.
Explaining the Optimal Quantity of a "Bad"
Mark A. Nadler, SUNY at Fredonia
This lecture is as much fun for the instructor as it is for the students. After discussing in class what is meant by the optimal quantity of a "good" through marginal private benefit and cost schedules, I then present to them the following situation:
"Assume that I'm running for Mayor. In the course of the election, I'm invited to your club or church to present my political views. I state in my speech that if elected Mayor, I'll allow crime and pollution to increase, and let our town's schools deteriorate."
By now, even the dullest student is awake and listening. I then ask my class whether it is logically consistent for a politician to advocate the existence of more "bads". Usually, the response is a resounding "no". I then proceed to draw the necessary social marginal benefit and cost curves to demonstrate the possibility of a political leader advocating the existence of more "bads".
This lecture raises some interesting ideas. First, the idea of an optimal quantity of a "bad". Second, that it is quite possible for a society's welfare to increase with the increase in the quantity of a "bad". And third, after redefining a "good" as something that society wants more of, and a "bad" as something society wants less of, it is quite possible to think of crime as a "good", and food as a “bad".
The Rear‑End‑Collision Prevention Light
Jack Adams,
As the consumer purchases that new automobile, an additional cost associated with governmental regulation becomes readily apparent. Yes, the now familiar Dole light to prevent rear end collisions. According to former Secretary of Transportation Elizabeth Dole (whose administration mandated the light, and for whom the light has been informally named), it has been estimated that approximately 900,000 rear end collisions could be prevented with the advent of this accident prevention installation feature.
Kits are now available for older model vehicles. Nevertheless, while the driver of the new car benefits, just as the other potentially involved driver, from any accident that is prevented by the light, it should be emphasized that in addition to this obvious social benefit anyone who avoids colliding with the owner of an automobile with a Dole light additional spillover benefits accrue to others through reduced automobile insurance premiums. Thus, lower policy premiums induced by "Dole light" accident prevention certainly represent external benefits which the rational consumer does not perceive in the quest for direct private benefits (i.e., prevention of being rear ended) by a Dole light purchase.
The requirement of Dole lights raised the price of autos just as requiring catalytic converters had raised car prices earlier. Even so, what about all the older model vehicles whose owners may choose not to install the light? In Figure 34‑2, the equilibrium price amounts to P. Next, assume a tax credit for consumers who install the Dole light. The ideal outcome would be additional light installations to the point where marginal social costs equal marginal social benefits. Alternatively, they could be made a mandatory requirement during a phase‑in period in order to secure a safety inspection sticker.
Figure 34‑2
Which would you prefer? While the answer becomes obvious, one must also consider which would be the most effective policy within a reasonable time constraint.
Is Competition Always Beneficial?
Gary M. Galles,
After covering the section of a principles course in which we show the "nice" properties of a perfectly competitive equilibrium and compare its virtues to the properties of the monopoly model, students can sometimes come away with the notion that "free" competition in any of its forms is always socially beneficial. To avoid this possibility, I use the example of toxic waste dumping to get across the point that there are limits to the types of competition that are socially beneficial, by emphasizing what can result in the cases of external costs as well as competition "outside the rules of the game."
I first ask how toxic waste dumping
is a form of competition. The answer is that in search of higher profits,
illegal dumping of toxic wastes is one way to lower production costs, which
either yields higher profit margins on sales at a given price, or lower prices,
attracting customers away from rivals; either raises profits. I ask them to
think of the case of the chemical company involved at
I conclude this example by using illegal dumping to illustrate how difficult it is to "crack down" on such activities. I ask whether announcing that a new cradle‑to‑grave tracking program for toxic chemicals would be initiated and take effect in a year would make things better or worse. This gets them to see the difference between near term results (increased dumping to beat the deadline) and longer term results (presumably, reducing dumping) as well as getting them to think about how expensive such contracts would be.
Anthony K. Lima,
I have found that this example is very useful in illustrating the difference between quantitative restrictions on pollution and taxes to provide incentives to control pollution. The example also gives the instructor another opportunity to emphasize the irrelevance of fixed costs to economic behavior.
The example revolves around the catalytic converter, which is installed on most automobiles today as a pollution control device. The converter acts as an afterburner. By using a platinum‑based catalyst, certain noxious gases such as carbon monoxide are further oxidized to much less objectionable forms. For example, carbon monoxide is catalyzed to carbon dioxide, which plants convert into oxygen. It has been estimated that the catalytic converter adds about $500 to the cost of producing an American‑made automobile.
Unfortunately, the catalytic converter requires that the owner of the automobile use only unleaded gasoline. The tetraethyl lead in leaded gasoline fouls the catalyst, rendering it useless. Unleaded gasoline is more expensive than leaded gasoline of the same quality. Therefore, there is an incentive for the owner of the car to use leaded gasoline to save money. The Environmental Protection Agency has attempted to forestall this possibility by making the fill necks on the gas tank of cars required to use unleaded gasoline much narrower than the necks on other cars. The gasoline pump nozzle is correspondingly narrower for unleaded gasoline pumps. Therefore, the leaded gasoline pump nozzle will simply not fit into the tank of cars required to burn unleaded gas.
It is amusingly simple to widen the fill neck to the extent required to accept the leaded gas pump nozzle. Many car owners have in fact done this. The point is that there is absolutely no incentive whatsoever for the owner of the automobile to not do this. Further, there are substantial incentives to widen the neck and mess up the converter. This has led the EPA to a new regulation: States must implement mandatory annual exhaust pipe testing for pollutants. These tests are of questionable value, as there is no evidence that they are at all consistent from car to car, or even from day to day.
A far simpler solution would have been to impose a differential tax on leaded gasoline, so that its price would be greater than unleaded gasoline. Students invariably respond to this proposal with the cry that it is unfair to the owners of older cars. The response is obvious: in any economic situation, there are always those who gain and those who lose.
Economics and Behavior Modification
Gary M. Galles,
To emphasize the point that economic analysis is mainly an analysis of people responding rationally and predictably to their incentives, I find the parallels between government tax and subsidy policies and behavior modification useful. I begin by describing the rudiments of behavior modification: you reinforce (reward) the behavior you desire and try to discourage (penalize) the behavior you don't desire, using whichever motivators a group of expert psychologists believes will work best (e.g., attention, peer pressure, overt disapproval, etc.).
I then point out just how similar behavior modification in psychology is to tax and subsidy policies. The classic prescription for an industry with "too much" output, such as the case of external costs, is to tack on a per unit tax equal to the level of marginal external costs to social optimum (i.e., penalize the external cost behavior at the margin). An industry producing "too little" output, such as the case of external benefits, similarly calls for a per unit subsidy (i.e., reward the external benefit behavior at the margin).
This example reinforces the point that economics is about how people respond to incentives, although those incentives and the behavior analyzed are usually restricted to certain areas. It also shows that just as psychological intervention may potentially result in better social consequences, so can government economic intervention in some areas. Finally, it shows how general and widely applicable the economic way of thinking is.
The Common Pool Resource Problem
John R. McArthur,
Students often fail to grasp the importance of private property rights in determining the efficient allocation of resources. When asked by the instructor why grizzly bears are scarce and an endangered species while horses are seemingly as abundant as ever, students often respond with blank stares. Only seldom, if ever, will a student answer "because horses are privately owned, grizzly bears are not." To illustrate the impact property rights can have on allocative efficiency, I play a game with the students.
Use about 20 round beads (buttons, marbles or other small objects can be used). I inform the students that the beads represent a common pool resource. For example, tell them each bead represents one whale, the classroom floor represents the ocean, and their desks are whaling ships. Tell the students that you will pay $.10 per whale in time period one, which should last no longer than one minute, and you will pay $.25 in the second time period, immediately following the first period. Indicate that these time periods represent the equivalent of several years. Throw the beads, scattering them on the floor (throughout the ocean). Inform the students that once a bead is picked up off the floor (the whale is harpooned) it must be turned over to the instructor (the buyer) in that time period. Storage is not allowed or is too expensive.
From past experience, I have found that the beads are always collected in the first time period. The students who gathered the beads (harvested the whales) should be asked why they did not wait one minute to earn an extra $.15. The response, of course, will be a recognition that waiting might mean surrendering a sure $.10 to their neighbor (another whaling ship). The expected value in time 1 exceeds the expected value in time 2.
After the
beads are collected from the first experiment, hand out beads to individuals,
informing them that they are the sole owner of that whale and that property
rights will be strictly enforced. The beads will be offered by students in the
second time period, earning $.25. Compare the outcomes, explaining why they are
different and pointing out the importance of property rights. This game was
originated by Terry L. Anderson at
Externalities and Consumer Prices
Ralph T. Byrns
When external costs are internalized, consumers pay higher prices for the product. Many students feel this is unfair because they believe the firms benefited from their pollution and should thus bear the cost of reducing it. Use supply and demand diagrams to show that in the absence of government programs to abate pollution, it is these exact same consumers that benefit.
Litigating Negative Externalities
George E. McCallum,
For non‑smokers, an excellent opportunity to introduce the idea of negative externalities presents itself when a student ignites a cigarette. Feigning strangulation ("Aaaaarrgh!"), assert that this miasma has gravely harmed your lungs and that you are going to sue him/her for "pulmonary trespass." Ask the class if the court won't surely award you damages. (They'll say "No.") What if you sue the tobacco company? ("No.") How about a class action on behalf of all aggrieved non‑smokers? (Doubtful without enormous legal expenses.) Although you have clearly been wronged and may easily have to bear extra costs (eyewash, throat lozenges, antihistamines) where such pollution is severe, there is no practical way to make the producer, and ultimately the consumer, bear (internalize) them. An interesting variant would be an outdoor party, where the smokers' acrid exhalations simultaneously drive away the mosquitoes (positive externality).
Bidding to Internalize Externalities
Les Morford,
Although smoking is not permitted in our classroom by edict of the Board of Trustees, I convince my students that we have been given permission to decide this for ourselves‑‑provided we decide the issue as a market rather than a political decision. When I ask how this might be done, there are such answers as "we'll vote on it," "the instructor will decide" or "each student will decide whether or not he or she will smoke during class." After generally unsuccessful struggles with the question, I tell them we will put the exercise aside for a while, following which we discuss private ownership of property, without reference to the smoking issue.
When we return to the smoking question, it is usually not long before the students suggest that the smokers will try to "buy" the rights to use the classroom air while the non‑smokers will bid to keep the air free of smoke. Only after one or the other of the groups has out‑bid the other do I confess that the Board did not give us permission to be an exception to the no‑smoking rule.
Why Do Even Nice People Litter?
Ralph T. Byrns
Ask whether your students have ever dropped a piece of paper or a cigarette butt on the ground on the rationalization to themselves that one piece of litter in an otherwise clean area does not matter. Now ask if any have littered in an already messy area while thinking to themselves that, because of the litter that already exists, their litter adds virtually nothing to the clean‑up costs that are already necessary because other slobs have preceded them. If you keep extending this argument, they will soon understand the cumulative nature of even trivial negative externalities. Point out that this same reasoning applies to the effect of one person walking across new grass, and then several more, and then the hundreds who, once there is a well worn path, think nothing of walking on the grass. You might also ask why people who think nothing of throwing aluminum cans out their windows as they drive down the highway are less likely to do so in their neighborhoods, and would never consider such littering once they've arrived in their own driveways.
Pollution: Market Failure or Government Failure?
Ralph T. Byrns
The book presents several market solutions to pollution problems including licensing (assigning the right to pollute at a cost) and litigation. Assuming that defining and enforcing property rights is an economic role of government, discuss whether pollution is a market failure or a government failure (government has either failed to properly define or enforce existing rights.) Then raise the question of whether government is truly protecting your rights to have your body or property unpolluted if you must bare the costs of going to court to have such rights enforced. Your students may also gain from a discussion about how reduction of pollution is much like a public good; non‑rival and non‑exclusive.
Notes: