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ECON20010 Fall 2013 - Lecture 7: Payment in Accordance with Product — Transcript

by Glen Weyl · 13,826 words · 1,994 segments · language en · Watch on YouTube

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0:01okay uh so as you come in if you haven't
0:05already please leave your problem sets
0:07over there um today uh we're going to
0:12move Beyond market equilibrium and start
0:16to think about policies which will sort
0:19of be the rest of the course so the rest
0:21of the course will be about policy
0:23analysis and um that will start by
0:26thinking about sort of the most
0:27fundamental area of policy which is
0:30externalities so I'm going to start by
0:33talking about the idea of an externality
0:35and try to contrast it with some of the
0:36Notions you may have learned say in your
0:38introductory courses about what an
0:40externality is um I'll talk about
0:44policies to solve
0:47externalities uh and how Pago's
0:49principle urges us to focus on
0:51addressing exactly the Distortion that
0:53takes place and not other related things
0:57I'll then uh help clarify try to help
0:59you clar ify the idea of an externality
1:01by talking about some things that are
1:03maybe surprising that are externalities
1:05and some surprising things that are not
1:07externalities but you might think would
1:09be so we'll talk about pecuniary
1:11externalities and the notion of
1:13internalities we'll then talk about
1:15public policy solutions to externalities
1:18and we'll focus on three areas pigouvian
1:21taxes uh the legal system and cap and
1:25trade which is uh uh basically putting
1:30uh a maximum on the amount of some
1:32activity that can take place but
1:33allowing people to trade the right to do
1:35that activity and we'll talk about the
1:37tradeoffs between these different
1:38approaches we'll then talk about
1:40stigler's Coast theorem and purely
1:42private solutions to externality
1:45problems uh how with property rights
1:47parties May might be able to bargain to
1:50efficiency and um I'll talk about why in
1:54some cases this or other private
1:56Solutions may work but I'll mostly
1:59emphasize the flaws in the coast theorem
2:01and the ways in which it ignores the
2:03importance of
2:05information uh and that will motivate
2:08the next lecture uh on Thursday
2:12okay so
2:16um is Victor
2:19here
2:21no uh anyone else want to give a basic
2:23Summary of why we found that the market
2:26mechanism worked so well in the last
2:28class yeah awesome because it provides
2:30better information on
2:33people's wants and so on and so forth
2:35than any other alternative
2:37system and in particular it
2:42um it forces you to
2:45pay for all of the consequences of your
2:48action it conveys a bunch of prices to
2:50people and those prices force people to
2:53pay for everything that they uh take
2:56away and rewards them for everything
2:58that they give right so if I want to eat
3:01more fancy dinners I have to pay for
3:03that because that means somebody else
3:04won't be able to eat those fancy dinners
3:06and what I pay is the opportunity cost
3:08to other people of those dinners the
3:10price that somebody else would be
3:11willing to pay to get the same service
3:13if I do a job I get paid for what that
3:17job produces for other people that's my
3:20wage um so in all these areas I get paid
3:24or pay what I give to or receive from
3:27other people and this principle is
3:29called payment in accordance with
3:30product and anytime this fails to happen
3:33we say that an externality exists and
3:36the reason that we call it an
3:37externality is not because it affects
3:39another person notice that in all these
3:42areas that we talked about you affecting
3:43other people but you were getting paid
3:45for it or you were pay being paid for it
3:48or sorry or you were paying for it but
3:51if you affect other people or really
3:53anything in a way that's external to the
3:56price system that's an externality so
3:59externality are effects external to the
4:02price system not effects on other people
4:05right so um Tanner can you give me some
4:09examples of
4:11externalities uh being really loud in
4:12your dorm at nights if you were trying
4:14to study yeah that's a classic example
4:16any any others you can think of um
4:19having the okay the uh the campus here
4:23beautiful yeah exactly paid for that
4:26yeah so it might affect other people who
4:28don't pay anything High Park they don't
4:30sure playing loud music beautiful
4:33building that people like to look at
4:34pollution is a negative externality
4:37generating new ideas is a positive
4:38externality because usually most of
4:40those people won't pay you for those
4:42ideas crime is a negative externality
4:44because you're not forced to pay unless
4:46you you know have a fine or something
4:48like that for the consequences of the
4:50criminal activity Yeah Austin speaking
4:52of generating new ideas you know how
4:53inventions are like patentable but
4:55business processes are not Y is there
4:58any is there any evidence so were there
5:00any situations in history where business
5:02processes were basically have patent
5:03rights around them some were reading
5:05like the joint stock company was
5:06supposed to be extremely important but
5:08obviously you couldn't
5:09capture so I
5:12mean I don't think that patents are the
5:16only way that people can capture the
5:19rents associated with a unique idea they
5:21come up with patents are one very
5:23important way but um there are other
5:27forms of intellectual property there are
5:28Trade Secrets
5:30there are um you know just the fact that
5:33you know how to do something better than
5:35anybody else there's fact that people
5:36want to buy from the originator of the
5:38idea so if you get famous for the idea
5:40you can get some rents associated with
5:42that so all of these ways of trying to
5:45allow people to appropriate the value of
5:47ideas have flaws because they all create
5:51various
5:52distortions uh or are incomplete and you
5:55know when we come to the lecture on
5:57intellectual property there will be a
5:59lot of questions about trying to balance
6:01the benefits and costs of different ways
6:03of rewarding Innovations um and we'll
6:06talk through
6:07those okay so a simple example of
6:12something that generates an externality
6:14is smoking so I want to go through uh
6:17you know simple uh uh analysis of that
6:22so imagine that there are 100,000 people
6:24in downtown Chicago each day and that
6:2710% of them are smokers and that to each
6:30person who's a smoker it's worth $3
6:34minus times the number that they smoke
6:36that's the utility they get minus the
6:38square uh of the amount that they spoke
6:40divided by 10 and imagine that cigarette
6:43prices are naturally
6:46$1 uh before we put any taxes on it yeah
6:49Mike um could you say something about
6:51how the value of smoking s is calculated
6:54like how you got to okay no I'm just
6:57making this up okay
6:59sorry yeah yeah I'm just making this up
7:01what was the S Square 10 3s was it
7:03utility so so three this is all utility
7:06but the the point is that like you know
7:07the marginal utility of an additional
7:09cigarette declines as you have more
7:12cigarettes okay so um if this is the
7:16situation Joan how much are smokers
7:19going to smoke um you want marginal cost
7:22to be equal to marginal utility so you
7:26find the Der of 3 S - s and is that um 3
7:31- 2 s/ 10 5 S and you equ that to 1 1 s
7:37right oh sorry to1 and then you find so
7:42what do you get um you can do it on the
7:44board or on your paper
7:59s equals
8:0110 um yep
8:05exactly
8:06um very nice John so let's imagine that
8:11the
8:1290 that uh the other 90% of people get
8:18disutility of one
8:22100,000th uh dollars for each cigarette
8:26that's smoked what would then be the
8:28socially optimal amount of smoking
8:32Tanner uh so you take the uh you
8:36subtract
8:37the you do the same thing you just did
8:40with the that added cost so yeah so
8:43what's the added cost for each cigarette
8:45smoked uh1 over 100,000 times that by 90
8:499 90,000 90,000 yeah yeah so that's 9/10
8:53right yes yeah so be
9:25so it would be uh 5.5 yes just 1.1 * 5
9:31exactly so um so now the optimal is 5
9:36and a half cigarettes per person rather
9:39than
9:41um rather than 10 right so one way that
9:45you can look at
9:46this show you want to draw
9:53it is that you know here was the private
9:57demand for cigarettes
10:00at a price of $1 people smoke 10 but if
10:04we add um an additional 90 cents to
10:10that we get
10:13here right which is
10:215 so um the fundamental social problem
10:26is that smokers don't have to pay for
10:27the harms that are created by their
10:28smoking
10:30and we're going to talk today about
10:31various ways of making them do that
10:33right now more generally if people are
10:37different um we have to try to maximize
10:40total welfare and take into account the
10:42total externality which means adding up
10:45across all of the different people how
10:47much each one of them is affected by the
10:50externality and this leads to Pago's
10:53principle of payments in accordance with
10:54product people M have to pay the average
10:58externality they of their actions
11:01multiplied by the number of people
11:02affected right and that's not just
11:04economics that's sort of Common Sense we
11:07think that people should have to pay for
11:09the consequences of their actions on
11:11other people right and markets make you
11:13do this for many things but
11:15externalities focus on cases where
11:17markets are missing and those tend to be
11:20cases as we'll talk even more about in
11:22the next class where the harms or
11:25benefits that you bring by your action
11:26are spread over many people when I'm
11:29just buying a good from you the cost of
11:32that good is just a cost that occures to
11:34you who sells it to me right you have to
11:36give up the good in order to give it to
11:37me but for things where there are
11:41externalities um the those tend to be in
11:45areas where like smoking many many
11:48people get a little bit of harm from you
11:49smoking and therefore it's hard for you
11:51to pay those people for the right to
11:54smoke
11:55right so the solution to externality
11:59problem problems is to focus on the
12:01absence of that price and try to figure
12:02out what that price should be that that
12:05smoker should have to pay um and in
12:09particular you don't want to just
12:12indirectly get at the problem if you can
12:14get directly at the relevant missing
12:15price so like in principle you could
12:18just make um for example cigarette cases
12:21expensive or you could ban cigarette
12:23cases well that might reduce the amount
12:25of smoking but it doesn't get directly
12:27at the problem and therefore it will
12:29cause other distortions right so let me
12:31give you a contrast to this so typically
12:34when you hear people in macroeconomics
12:35talking about fiscal policy they say oh
12:37we want people to spend more so let's
12:40just hand out money or let's just uh
12:43build a project and then people will get
12:45money and they'll spend it that doesn't
12:47get directly at the problem right the
12:49direct problem is that people aren't
12:51spending enough so rather than just
12:53giving them money and hoping they spend
12:54it you should probably give them money
12:56if they spend it by reducing sales taxes
12:58or sub subsidizing the purchases of
13:00goods that would be the more pigouvian
13:02answer to that problem so you see that
13:04even within economics there's a lack of
13:06sometimes understanding of Pago's
13:09principle that you should try to Target
13:10exactly the uh things that are causing
13:13the problem okay so now let's talk about
13:16something which might seem to be an
13:18externality uh and we'll have to think
13:20about whether it really is so imagine
13:23that I discover a giant horde of gold
13:26and the prices on gold fall and this
13:29hurts people who currently own gold
13:31because their gold is now worth less
13:33right is this an externality again is
13:36Victor here
13:38no um anybody else want to venture an
13:42opinion about that uh yeah remind me of
13:44your name tavish well are the I anyone
13:47who buy yeah people that already own the
13:49gold get less money for it those who are
13:51buying it spendless exactly so because
13:56this is mediated through the price
13:57system right um there's an offsetting
14:01benefit accompanying the cost while
14:04people who currently own gold are worse
14:06off people who could potentially acquire
14:08gold are better off right and because
14:11this is mediated through the price
14:13system there is no net loss to society
14:16associated with you finding gold so
14:18unlike a real externality there's no
14:21efficiency loss here and therefore we
14:23should not penalize people for creating
14:25pecuniary
14:26externality and in fact some of the most
14:29common misapplications of the theory of
14:31externalities are to these types of
14:34pecuniary externalities because people
14:36often mistake any effect I have on
14:37another person for a uh real externality
14:42so for example imagine that a competing
14:45firm enters an industry and lowers the
14:47prices that all the firms get for their
14:49goods you could say well that's an
14:50externality but that's not really an
14:53externality because it's going to
14:55benefit the consumers as much as it
14:56harms the firms now let me give you
14:59another case um suppose that that firm
15:02enters the industry and it doesn't
15:05actually reduce the prices all it does
15:09is take away some of the sales that are
15:11currently being made by existing firms
15:15is that uh an externality uh so what do
15:19you think um I don't think so because
15:21they whatever Surplus can be getting
15:23that firm gets it instead so well
15:25actually sorry if you're looking at it
15:26from the firm's point of view um so I'm
15:28I come into the industry prices don't
15:30fall at all firms are making positive
15:33profits on every unit they sell and I
15:35just steal some of the business away
15:36from one of the other fir that's an
15:37externality because um you're you're out
15:39of the picture you're like everybody
15:40else who's not involved in that
15:41transaction is being negatively exactly
15:44that's right Mike did you have a
15:46question uh no
15:48okay
15:51um okay uh free trade with China might
15:56cause Steel Workers to lose their jobs
15:58but not really a real externality if the
16:01price of Labor is just falling uh as a
16:04result of that polluting a lake could
16:08harm
16:09consumers uh because the price of
16:13fish because you know there were fish in
16:15that Lake the price of fish could fall
16:18or rise sorry because there's not as
16:19many fish but that would benefit the
16:21producers of other fish right uh because
16:25they would experience a rise in price of
16:26their fish now of course polluting the
16:28Lake does have to have some externality
16:30on someone right you're destroying
16:32something so the question is who is the
16:34real victim of the externality Mike
16:36fosco um the consumers for health
16:39benefits from the fish or probably or
16:41health tradeoffs this probably have the
16:43health is do it like
16:46that but you're destroying some fish
16:48right so the question is who's the
16:50direct victim fish would
16:54they well we don't usually think of fish
16:57as agents in in our models the farmers
17:00are getting a lower surplus of fish to
17:02use um through this pollution but the uh
17:05firm is not being for the question is
17:07who owns the fish right if someone owns
17:10the right to fishing in that Lake then
17:12whoever owns that right is the one who's
17:13the victim of the externality if no one
17:15owns the right to fishing in the lake
17:18but de facto there's a bunch of people
17:19who go and fish it it's the people who
17:21are extracting those fish from the lake
17:23who are harmed right so it's whoever is
17:25the de facto owner of the right to fish
17:29those fish yeah Philip doesn't uh where
17:32the harm Falls depend a lot on the
17:36elastic like if fish is sufficiently
17:40like the demand for fish is sufficiently
17:43in elastic like there might be a large
17:46increase in price for even a relatively
17:48small drop on quantity well but that
17:50that only affects how the pecuniary
17:54effects are divided but it has no effect
17:56on the real effect of the ex
17:59yeah Evan so would the fisherman be said
18:02to be harmed by this um they're the ones
18:06with de facto right well if they have
18:07the defacto right but if someone else
18:09owns the right to the fish but they sell
18:12a license to the fisherman then whoever
18:14owns the right to the fish will okay
18:17will have it so why are consumers not
18:19considered to be because they are just
18:22buying the fish in the marketplace
18:24they're just like the people who would
18:27uh you know buy the permits the
18:29fish they're just someone who's down the
18:32road who's affected only via the price
18:34system and not directly by the
18:35destruction of the
18:37property yeah Tanner but there are some
18:40people like not just price exality there
18:42are some real externalities in the
18:43system right if people enjoy fishing at
18:45the lake that would be if people get
18:47some pleasure out of fishing at the lake
18:48and they don't pay an entrance fee for
18:50that yes that's right so that's what
18:52it's the key is is there a price that's
18:54capturing things if there's a price
18:56that's capturing things then it's not an
18:59externality but if there's not a price
19:00that captures the way in which the harm
19:03is transferred then there probably is an
19:08externality okay uh another example of
19:12this is imagine you have a brilliant
19:14roommate who usually breaks the curve
19:17but got stoned last night right so you
19:19could think that creates a positive
19:21externality on everyone in the class but
19:23that's actually not right because it's
19:25pecuniary the like basically how
19:29valuable the grade is is like a price
19:32right and so even though the that guy is
19:35benefiting everyone in the class it's
19:36hurting by an equal amount everybody
19:38else at the University because now the
19:40perception among the broader world is
19:42going to be that people from the
19:43University for a given grade or less
19:45smart even though that's tiny tiny
19:47effect right uh it's spread over a large
19:50number of people and those exactly
19:51balance each other Yeah Austin how do
19:53frictions fit into this what how do like
19:55frictions fit into this CU I feel like
19:57imperfect imp infections in the market
20:00well I mean the example that I gave of
20:03the um of like coming into a market
20:07where there's Market power and therefore
20:08firms are earning a positive markup and
20:10stealing some of the goods from another
20:12firm that's that's one example of a
20:15model with frictions where we can divide
20:16things into real and pecuniary effects
20:18it just seems like to this last one for
20:20instance because University reputations
20:22are durable over hundreds of years in
20:23many cases that like even though
20:26technically but in the very long term it
20:27will have a very very small effect on a
20:29large large number of people right
20:34um so another example of this is like in
20:37China and East Asia there's often a lot
20:39of selective abortions of women and you
20:42could say that this makes the women
20:44other women better off because they have
20:45less women to compete with for uh the
20:48men in the society so maybe that brings
20:50them an externality but the men have
20:52fewer women that they get and so
20:53effectively there's like a price in the
20:55labor Mark in the marriage Market that
20:58uh is is equilibrating and that means
21:00that this has offsetting effects on the
21:02two sides and therefore is a pecuniary
21:04externality so even when it's not a
21:06literal Market there can be price- likee
21:08mechanisms when there's competitive
21:10things going on yeah philli oh sorry
21:12yeah D um if you go back to the example
21:15of the firm entering a market using
21:17Market power doesn't that firm benefit
21:20from the LA of and those people why does
21:24why it still oh but I mean if I steal a
21:27computer from you
21:29I benefit and you lose by the same
21:31amount right so that's if we didn't call
21:34that an externality nothing would be an
21:35externality right the fact that I
21:37benefit can't possibly be an offsetting
21:41thing in an externality for me doing
21:43damage to you right it has to be
21:45offsetting effects to people other than
21:48me okay
21:49right um remind me of your name MIT
21:52Mitch yeah does that basically mean that
21:54like the in order for them there to be
21:57an externality say in the case of
21:59stealing a computer the marginal the
22:01marginal benefit to you has to be uh
22:04somehow let's say less than the marginal
22:07cost of losing a computer say to some
22:09guy computers no no no no no that's
22:12exactly I what I said to Dake is not
22:14true it's always causes an externality
22:18if I hurt on net people other than
22:20myself right but I'm saying what if what
22:22if it doesn't equalize such that you get
22:24the benefit of a computer but say you
22:27don't count you don't count you don't
22:29you don't count my benefit at all when
22:31Computing
22:32externalities that's the key point you
22:34only affect the effects on all people
22:36other than you so if it has offsetting
22:38effects on people other than you then
22:40it's not a real externality but if it
22:42has a benefit you know cost to you and a
22:44benefit to me that is an
22:48externality so you can only when doing
22:50these offsetting things think about
22:52affects to people other than
22:54myself I I guess what I'm asking is
22:56whether the offset has to be equal in in
22:58order for there in order for you to say
23:00that there's no externality yes the
23:01offset has to be equal so if the offset
23:03is not equal then there is an
23:05externality or not necess yes there
23:07is that's I mean and the price system
23:10ensures that things are perfectly
23:11offsetting that's the
23:13idea yeah
23:15Phil would there be other externality
23:19effects let's say when a firm enters and
23:21lowering lowers a price would there be
23:24an externality in experienced on the
23:26extra units if demand increased so like
23:30consumer being Society gains and that so
23:33if the price if the price goes down
23:36which is the only time when the total
23:37number of units will increase that can
23:39create an externality if there's
23:41currently Market power in the industry
23:43because the market power is effectively
23:45a unpriced externality that exists
23:48before and the reverse happens if fish
23:51sales go down because the price of fish
23:53Rising right no because it's only true
23:58if the the market for fish is not
24:00competitive so what I said is only true
24:02if there's an imperfectly competitive
24:04market okay but if the market is perfect
24:07competition then the effects perfectly
24:11offset and for the selective abortion
24:15case there could still be like an
24:18externality due to selective abortion
24:20because people prefer being in a society
24:23with an even ratio so everyone can marry
24:25instead of a society with a how least
24:28ratio which leaves some people unmarried
24:31because like myor woman run out right
24:34yeah but I mean that's sort of not a
24:35directional effect it's like one that's
24:38about whether you're at the Tipping
24:40Point or not you know what I
24:42mean
24:44like you see what I'm saying I mean
24:46again that that's that's it's like the
24:48market power thing that you're you were
24:49saying before if like the market for men
24:52is more concentrated than for women then
24:54on average men will have like a little
24:55bit more Market power or if there's
24:57fewer women that women will have a
24:58little bit more Market power and yes
25:00there will be a little externality that
25:01comes from reducing that market power
25:03but not one that comes just from the
25:05like if it was perfectly balanced one
25:07man disappearing would be have exactly
25:09balancing effects that's the idea is
25:11this assuming infinitely large
25:13population because if in a finite
25:15population one man disappearing implies
25:18one woman it doesn't assume effic
25:20infinitely large the effects will be
25:22very close to what I said if it's if
25:24it's finite so then so then it like the
25:27real externality would just be one woman
25:29can't be married yeah but that but that
25:32one woman is going to be like way down
25:34the desirability charts right and so uh
25:38she like her opting out is not going to
25:40have much like net harm I mean that's
25:44basically what it comes
25:46to uh yeah did anyone else have
25:49questions yeah reishi so in the case of
25:52the firm again um which which comes in
25:55takes my competition that's only an
25:57externality if there's Market power in
26:00that industry yeah because then I'm
26:02taking away profits that another firm is
26:03earning it's perfectly competitive and
26:06yeah exactly yeah aome this is kind of
26:08random just going off how much evidence
26:11is there that the marage market is
26:14actually uh okay there's a lot to be
26:17done about you can read Pier Andre Ker's
26:20work on this he's been working on this
26:22recently I I don't I don't want to get
26:24into it it's very complicated but but
26:26it's it's clear that there's
26:27multi-dimension heterogenity and
26:29multi-dimensional matching and that it's
26:31not just one toone ranking but all those
26:34different attributes can be priced and
26:36so you can still get the same sort of
26:38effect um yeah J intent doesn't have
26:42anything to do with it right like
26:43suppose you have someone who is
26:45extremely fobic externalities is
26:47completely invariant to intent we'll
26:49talk about intent later actually but
26:51we're completely invariant to intent so
26:53like even in fact even if like you could
26:56never have foreseen what you were doing
26:58you still if you had any causal role in
27:00it can be thought to create an
27:02externality marginal still like this is
27:05roughly the same thing which was asking
27:07but um Robin every time he takes from
27:10like rich people and getes support
27:12people he's creating positive
27:13externality no because if he doesn't
27:15keep the money yeah yeah no but he's
27:18creating a positive oh positive people
27:20with like a higher marginal value yeah
27:22so if you think that they have greater
27:24marginal utility yeah then that's a
27:26positive externality so that's why like
27:28you know you would like Robin Hood
27:30that's the idea you know I mean but on
27:33the other hand he's also in creating a
27:35deterrent to labor right and so you have
27:38to trade those two off but if you live
27:39in a society where there's like
27:41suboptimal amounts of insurance which
27:43presumably feudal England in like what
27:45what is it like the the like 12th
27:47century or something like that or 11th
27:49century was presumably a place where
27:51like inequality was probably higher than
27:53was socially optimal so if that's the
27:55case the Robinhood is good yeah
27:58okay so um this distinction shows up
28:04pretty heavily in the
28:05law so there's a distinction in the law
28:07between the notion of physical
28:10damages uh and pure economic losses and
28:13this really corresponds very closely to
28:15the notion of real and pecuniary
28:16externalities So Physical damages is
28:19like I'm driving my car and I hit a
28:21doctor with the car and the doctor dies
28:25and that you know is a pure that's a
28:29standard externality on that doctor or
28:31if I burn down my house and that catches
28:34fire on other people's houses and burns
28:36those down too that's also a real
28:39externality or if you defame someone's
28:41rightful character with liall and you
28:44know spread un untruths that's not
28:46physical but it's called like a physical
28:48damage right pure economic losses are
28:52very different on the other hand so if I
28:53kill that doctor and that
28:58um causes like the price of getting a
29:00doctor in that town to go up well that's
29:04the harms that that does to Consumers
29:06are going to be offset by the benefits
29:07achieved by the other doctors by able to
29:09being able to raise their rates and
29:11that's not an externality if I burn my
29:13house down and that causes the prices of
29:17other houses to rise because now there's
29:19not as many houses in the neighborhood
29:22that's not a positive externality that
29:24that action had on other people in the
29:26neighborhood because it hurts the people
29:27who might buy those houses right now
29:30here's another case imagine I burned
29:31down my house and that actually causes
29:33the prices of other houses in the
29:35neighborhood to fall because I had such
29:37a beautiful house that was making the
29:39neighborhood nice and now there's like
29:40an empty lot there and therefore the
29:42prices of all the houses fall um Victor
29:46is not here uh any anybody
29:49else uh yeah D doesn't that still cause
29:53damage to the people who own the houses
29:55because all of a sudden they're holding
29:57hous that was but that sounds like it's
29:59mediated through the price system so is
30:01it a real externality no it's not a real
30:03externality what is what other people
30:06think uh yeah Adam um yeah it wouldn't
30:09be an externality because uh consumer
30:12houses would benefit from the the Dr do
30:16they what do you think Julian um I think
30:18it is an externality because there was
30:21previously a positive externality and
30:23from the house being beautiful ising
30:25home prices and not your moved it
30:27exactly and in
30:29addition uh what um Adam just said is
30:32wrong right because the new buyers of
30:34the home don't get benefited the price
30:36Falls but the house is less beautiful
30:38and so those offset each other right and
30:40so you're left with the net harm to the
30:43current owners and and Julian is the
30:46explanation of why Adams is wrong
30:48basically okay so but on the other hand
30:50if everyone in the neighborhood was
30:52paying the guy like money for how much
30:55he was making the neighborhood better if
30:56he was getting some award from the
30:58community for that then that second
31:01effect would be a uh would be a purely
31:05pecuniary externality because those
31:08people even though they lost the house
31:09they would also lose the tax that they
31:11had to pay in order to fund the guy's
31:13award for having a nice house and so
31:15they would be the same amount off right
31:18so yeah Christian so even like not
31:22necessarily creating a new negative
31:24externality but just eliminating an
31:25existing positive one those are EX actly
31:28the same thing there's no positive I
31:30mean in economics in general people
31:33often talk about benefit cost analysis
31:35and in fact we will all that a benefit
31:37is is a negative cost and all that a
31:39cost is is a negative benefit I mean you
31:41can just move them around on the two
31:42sides of the thing and there's no real
31:45distinction between those things so yeah
31:47from an economics
31:48perspective okay so during the deep
31:51water Horizon uh disaster there were a
31:55huge amount of issues trying to figure
31:57out who actually was owed money and who
31:58was not based on these types of things
32:01so for example are the shrimping
32:04employees who lost their job as a result
32:07of the deep waterer Horizon disaster
32:10actual victims uh in the externality
32:13sense of the deep water hor Horizon
32:16disaster is Matas here I don't think he
32:19is uh anyone else want toine on
32:22that uh yeah go ahead to I guess I guess
32:26no it's the owner like the pure economic
32:28loss to the owner and then like through
32:30the prices there's a less like smaller
32:32reduction demand for the triping
32:35employees yeah but except you got the
32:36terms reversed the physical losses to
32:38the owner uh and the pure economic
32:40losses to them yeah that's right
32:44um uh so how about a government
32:47conservation agency that is the
32:48responsibility for protecting the birds
32:50that were killed by the deep water
32:52Horizon oil spell um anyone want to take
32:56that Victor's not here so uh Evan wait
32:59was it I just want was it really Victor
33:00again yeah it's like literally VI you
33:03know the thing is with random number
33:04generators there's an extremely high
33:06probability that you get a long run of
33:08the same person over and over again and
33:10it turns out that it's him and he's not
33:12here so yeah Evan yeah so government
33:15conservation agency would be the group
33:18that is actually responsible for the
33:19birds suppose we could say they have a
33:21form of indirect ownership yeah so I
33:23mean that there's a a physical loss to
33:25them yeah so you can think of those
33:27people as being the agents for society's
33:30interest in that right it's the same way
33:32that like you know a business person is
33:34the agent for the business similarly
33:36these people are like put in charge of
33:38taking care of the society's interest in
33:39having those birds there and so they are
33:42sort of the owners effectively of that
33:45interest um yeah you want to go in ask
33:48would you say that so for say you have
33:50people whose jobs were catching birds
33:53and using them for shows would we say
33:55they have a pecuniary loss uh well if
33:58they paid the um owner who was like this
34:02Agency for the right to you know borrow
34:07those birds then they then that would be
34:09a pure pecuniary loss but if they sort
34:12of if nobody was like paying attention
34:15to the birds and they could just go in
34:17and catch them and no and they weren't
34:19paying anything for it and they were
34:20getting a benefit out of it yes then
34:21they would have a loss so that's the
34:24idea
34:26um I think
34:28that I'm going to move on because I
34:31think we need to get through this
34:32lecture but I'll come back hopefully
34:33we'll have some time at the end we can
34:34answer some more questions these are I
34:36know these are a lot of like brain
34:38teasers it's sort of like math puzzle
34:40Eon economics versions of math puzzles
34:42but I'm trying to go through a bunch of
34:43examples to try to calibrate how you
34:45guys think about them um how about the
34:48Louisiana Hotel industry that served
34:51people who are business people who came
34:53to work in the shrimping or seafood
34:55industry in the Gulf uh Julian what do
34:57you think about that no cuz they they
35:00didn't own any other things that were
35:02like directly damaged by The Horizon
35:06spill yeah so they um they might have a
35:11reduction in the hotel rates but they'll
35:13still fill those hotels with people who
35:15are coming for tourism because now it'll
35:18be really cheap to go on tourism in in
35:20Louisiana right so
35:23um how about disrupted um shippers who
35:28used to ship through the port of uh New
35:32Orleans is is abanov here I don't think
35:35he is
35:36right uh anyone else want to take
35:40that
35:42um uh yeah philli it's a real
35:45externality because they pretty much had
35:48the right to go through they was
35:51understood that they had the right to go
35:53through the water but now someone messed
35:56up the water so they can't go through it
35:58yeah so that's true if they weren't
35:59paying anything yeah for the port but if
36:02the port was like owned by someone and
36:04someone was charging a market rate for
36:06the port then the like then the crappy
36:09quality of the port will cause the price
36:11to come down uh and they were paying the
36:13full benefit anyways so that that's not
36:16a real externality at that point true
36:17yeah Tanner well like I'm not sure if
36:19it's true but you go to a port you have
36:22like your like a company have its own
36:24station you know that they Shi it's
36:26unloaded would don't like each yeah so
36:28if they have ownership of a station then
36:30they would be an owner yeah that's right
36:32then it would be a reality they own
36:34something exactly yeah so it all depends
36:36on who it's all it's always accruing to
36:38the owner of the thing which is damage
36:40rather than to people who are indirectly
36:42harmed through the change in the
36:44economic environment that that's the
36:47thing to keep in
36:49mind so not everything across people
36:53yeah Mike I question about the question
36:56yeah um
36:58what if the port is like already a
37:00crappy port or something and the price
37:02is low and it's like and like for
37:04example they can't lower prices enough
37:07to like make up for the externality and
37:09still make like running a port
37:10sustainable or something like that well
37:12but then then there's not any loss
37:14because like basically the port wasn't
37:16creating much value in the first place
37:19right because they weren't able to
37:20charge enough to make to cover their
37:22costs okay right so there's no loss then
37:25so changes in prices like are there
37:28cases in which changes in prices might
37:29be insufficient to cover externalities
37:33if something's not like a real
37:35externality as long as the damage can
37:37sort of like adjust through the price
37:39system and people aren't losing rents so
37:44people could lose rents like imagine
37:46that I've made a investment in being
37:50good at going to this port right and I
37:54earn some Surplus off of that right and
37:58now like it's not just that like the
38:00price goes down of the port but the port
38:04suddenly now shuts down as you were
38:05describing but I've made some investment
38:07that I was earning Surplus off of then
38:11that would have a real externality on me
38:13so you have to always think about what
38:15things could be mediated through the
38:16price system or what things might be
38:18like a discrete change from which I earn
38:20a surplus but if the guy was perfectly
38:22price discriminating and was extracting
38:25my Surplus then
38:27wouldn't uh be a real externel you see
38:30what I'm saying it all depends on
38:32whether you're earning some like
38:33uninternalized rent off of this
38:36thing uh D yeah wait so to clarify
38:39physical damages are actual
38:40externalities of exactly exactly
38:45yeah okay so not everything that happens
38:51across people is a real
38:54externality but in in cont cont not
38:58everything that happens within people is
39:00actually just fine and efficient so in
39:02fact there can be externalities within a
39:04person because externality does not mean
39:06across people it means not captured by
39:08the price optimization system and the
39:11price system remember is just sociey
39:13lrange multipliers so if within you
39:15you're not having a lrange multiplier
39:17that takes into account something that
39:18affects you that can be uh an
39:21externality as well right usually these
39:23are called internalities because people
39:25didn't understand the source of the name
39:27of the word externality uh but and
39:31thought that it was about but anyways so
39:34we'll call them that too and policies
39:36that address these are usually called
39:38paternalism and these are really based
39:39on the same idea that there are things
39:41that you do to affect yourself that are
39:43not taken into account by the way in
39:45which you optimize just like the market
39:47fails to take into account externalities
39:50right and large areas of policy are to
39:52at least some extent determined by these
39:54considerations uh so for example
39:56addiction and Drug drug I think is to a
39:58large extent you know the reason why we
40:00have drug policy is because we're
40:01worried that um people might harm
40:05themselves in a way that they don't
40:06fully or correctly take into account
40:10um uh Force savings and Social Security
40:14are another example of this people might
40:16be tempted not to save but they would be
40:19better off
40:20saving uh Energy Efficiency standards a
40:23lot of people think that people failed
40:25to take into account how much money they
40:27could could save if they got a more
40:28efficient car and in fact most of what
40:30the government uses to justify the fact
40:32that it forces companies to have high
40:35energy standards is exactly the effect
40:39that people will benefit themselves from
40:42having lower energy cars not that
40:44they'll benefit the environment and in
40:46fact um it turns out this is something
40:49people don't know because everyone's
40:50like oh to save the planet I should
40:52really be having a Prius or whatever but
40:55actually Cafe standards
40:57by almost any calculation you do Force
41:00more fuel economy on cars by far than
41:03could be justified by any optimal carbon
41:06tax so like we're already having more
41:08fuel efficient cars than you would want
41:11to if you were just trying to deal with
41:13the externality associated with uh
41:16Carbon on the world which is kind of
41:18interesting so uh instead you have to to
41:22justify these things things people are
41:23like actually hurting themselves by not
41:25taking into account the future price of
41:27oil and there's a little bit of a um
41:31evidence for this so there's a reason
41:32Bor by uh alott and uh Nathan wosy
41:36which shows that when the price of oil
41:37changes people don't change their
41:39purchases of cars as much as they do in
41:42response to price once you've converted
41:44the oil price into dollars and so forth
41:47and therefore that like people are
41:49probably not fully taking into account
41:51the effect of oil but the effect is much
41:54much smaller so that even than the cafe
41:56standards required so even if you add
41:58Cafe standards and optimal carbon Tex
42:01sorry even if you add this effect plus
42:03the optimal carbon taex still the cafe
42:05standards are way too strict so it seems
42:07unlikely that those are like actually
42:09the optimal thing to be doing yeah
42:10philli how are we sure that people
42:13aren't just thinking that this price
42:15increases transitory because you can
42:17look at the Futures prices of oil and
42:19those tell you about the future the
42:21changes that they should be expecting
42:23about the future of oil okay so this is
42:25taking Futures prices oil is assum
42:28exactly yeah yeah Tanner what do they
42:30Define as
42:31optimal how do they get that figure well
42:34the optimal thing would be if you do the
42:37calculation of all the externalities and
42:39you take these estimates and then you
42:41figure out if we were to put all the
42:42optimal taxes on what would people be
42:44doing then Cafe standards are much
42:47stricter than that that's the
42:50idea uh I think we need to go on sorry
42:53uh okay another example of this is
42:56suicide or organ donation or
42:59prohibitions on other sorts of markets
43:01like prostitution most of those are I
43:03think justified by some sort of negative
43:06effect that we think people are choosing
43:07to have on themselves okay now most
43:11economists favorite response to
43:12externalities is taxation if the
43:14externality is harmful tax the activity
43:17if it's beneficial subsidize it um and
43:20this is a simple solution because it
43:21directly creates a price for the
43:23relevant activity now the tax has to be
43:26set equal to the marginal externality at
43:28the optimal level of the activity so
43:32imagine that um so in my example here
43:35the amount that smoking cost people
43:39like uh was constant but imagine that
43:42like as people smoke more it gets more
43:45costly so the costs look something like
43:48this well then what you'd want to add um
43:53is um the am the amount the tax that
43:57you'd want to impose would be at this
43:59level here not at this level here or at
44:02that level there right you want to
44:04impose the amount of tax that's equal to
44:06the optimal uh to the marginal
44:10externality at the amount that is
44:14um at the socially optimal amount so
44:17it's not just the marginal uh social
44:19cost anywhere it's the marginal social
44:21cost at the optimum because if you don't
44:23impose that you won't get to the optimal
44:25quantity now
44:28even that is not always going to be
44:32sufficient to achieve the socially
44:34optimal quantity so the thing I was
44:35trying to point out here is you don't
44:37need to just think about oh what is the
44:40cost you need to think about what's the
44:42cost at the optimal quantity but in
44:44addition to that even imposing just that
44:46marginal externality at the optimal
44:48quantity won't always be sufficient to
44:51achieve uh the social Optimum it is in
44:54this example but you can consider
44:56another example so think of uh fax
44:59machines so or Facebook or any other
45:03industry where like it's only valuable
45:05to use it if other people are using it
45:07right and you could say well that means
45:10that there's an externality on other
45:11people when I use this technology so
45:13maybe there should be a subsidy on me
45:15using this technology right um but if
45:18you just imposed the benefit to people
45:21of having one more person on the network
45:24um at the optimum like what do you think
45:26the benefit of like one more person
45:28getting onto Facebook is I don't know
45:30maybe the externality in other people is
45:31like some amount but it's not something
45:35huge uh the problem is people might not
45:39get onto the system even in exchange for
45:41that subsidy if they don't think anyone
45:43else is on the
45:45system right and as a result of that um
45:50you could have the system even though
45:53it's socially beneficial and the optimal
45:55level is that lots of people use it
45:57uh no no one might get on right so you
46:00might have to subsidize a lot more than
46:02that at the beginning to get people onto
46:04the system so that eventually you can
46:06get to this optimal level and in fact
46:08that's what pretty much every internet
46:09company does right they usually charge
46:11these incredibly low prices early on and
46:14like you know really do all this stuff
46:15to get people to use it in order to Spur
46:17adoption and then once the system has
46:20developed and people can benefit from
46:22other people using it they lower the
46:23prices right so sometimes it can be
46:26optimal to sub idiz much more early on
46:29in order to get the thing up to
46:30efficient scale right and this idea is
46:34called the insulating tariff and it
46:35comes from a paper that I wrote a few
46:37years
46:38ago so um there's the um the most common
46:44application of paguan Taxation is to
46:48dealing with
46:49pollution um so in uh there's a notion
46:54that was proposed by Lawrence white
46:56called e taxation which is rather than
46:58requiring that you have like you know
47:00something that cleans up the exhaust
47:02from your car to a particular degree
47:05instead he he argued that every time
47:07your car gets inspected the local
47:10Authority that inspects your car should
47:12assess attacks that's based on how
47:15harmful pollution is in that area
47:17because you know out in the middle of
47:19rural Nevada it's not all that harmful
47:21to uh be driving around a polluting car
47:24because it's just gets dissipated in New
47:26York City it's really harmful right and
47:29so you might want to have gradated uh
47:31taxes on that that allow people to
47:34figure out whether it's worth it to them
47:36to buy those things that will reduce the
47:38amount of uh emissions that they're
47:40putting out yeah Mitch I'm I'm not sure
47:42I understand why uh like the the tax
47:47would necessarily be lower say in in a
47:49rural area where wouldn't you just be
47:51creating the same amount of pollution as
47:53in New York no but the thing is it
47:55doesn't it doesn't hurt people
47:57to create pollution because there's no
47:58one to smell the pollution and there's
48:00no one to get sick from car in New York
48:02doesn't you don't really see the effect
48:04of that either no you do I mean like
48:06added so first of all there's nonlinear
48:08things in congestion where like actually
48:10if you have like a little bit it doesn't
48:13bother People's Health at all until you
48:15get quite a bit uh and it and it is
48:18convex like that so it does like every
48:19additional car in New York does a lot
48:21more harm plus it does more harm to more
48:23people so it's definitely it's
48:25definitely worse um okay so uh his idea
48:30was to have all the localities charge
48:32different taxes now uh FR in France they
48:36have pollution taxes for every um
48:40Factory uh and there's like a little
48:42thing sensor on the Smoke Stack of every
48:45Factory and it measures like a 100
48:47different chemicals that you let off and
48:49for each one of them you get charged
48:50some tax um people have also advocated
48:54having a carbon tax worldwide and we'll
48:56talk a lot more about this on Thursday
48:58but this is used in Europe now
49:00economists usually prefer this sort of
49:02response to pollution over directly
49:05coming into factories and telling them
49:07pollute this much you know implement
49:09this particular thing and uh why is that
49:13uh
49:14tavish um
49:33why why why don't economists want you to
49:35just be forced to um you know uh adopt
49:40or not adopt some technology why do they
49:41want why they want it to just uh like
49:45for you
49:46to yeah why do they want you to like you
49:49know pay a tax on the externality you
49:52cause rather than just have the
49:54government come in and say use this or
49:56use that if you're able to do it more
49:58efficiently again there kind compartive
50:01Advantage if you're able to do it more
50:02efficiently yourself just by by reducing
50:07pollution you do that otherwise the
50:09prices allow people to basically trade
50:11right it allows people who are able to
50:12do it more to do more of it and people
50:14able to do it less to do less of it in
50:16fact there is a study recently by
50:18Meredith fley and her co-authors that
50:20showed that because the system wasn't
50:22working like this that we were losing a
50:24lot of potential gains so what she
50:26showed is that like cars aren't um
50:30checked for how much uh nitrous oxide
50:32they put out even though it's a small
50:34amount they put out some but factories
50:37are so the factories have to pay for it
50:39but they can't pay the car owners to do
50:41it instead and that's really inefficient
50:44because cars turns out could get rid of
50:45KNX much more cheaply than factories
50:47could and they estimated you could save
50:48$2 billion by allowing that trade to
50:50take place um okay now in the US many if
50:56not most most pigouvian taxes are not
50:58collected through the uh through like
51:00the tax system but through the legal
51:02system so when a firm or an individual
51:04causes harm they get sued and the course
51:07Court assesses how large the harm was
51:09and the individual causing harm has to
51:11pay what are called compensatory damages
51:14that directly redress the harms caused
51:16but sometimes they also have to pay
51:18punitive damages and these punitive
51:20damages deal with a couple of issues one
51:22is that not everybody who's causing a
51:24harmful externality gets caught doing it
51:26and so they multiply up the damages so
51:30that on average given your probability
51:32of getting caught the uh expected amount
51:35of Damages you pay is equal to the harm
51:37that you caused but another reason you
51:39can pay these punitive damages and not
51:41pay them to the person who actually uh
51:44was harmed but to the government is that
51:47they don't want to give too much
51:49incentive to someone who might be able
51:51to avoid being harmed to try to get In
51:53Harm's Way just so they can get the
51:55damages right right or to avoid taking
51:58care to avoid the damages uh just so
52:00that they can get these benefits right
52:02um and maybe the current problem set or
52:05maybe a past problem set dealt with this
52:07I'm not completely sure um so the
52:11anglosaxon legal system really
52:14incorporates Pago's principle into it
52:16and you know everyone always talks about
52:18how litigious uh we are in the United
52:21States how there's all these lawsuits
52:22and it drives people crazy but um in
52:26Europe where they have many less
52:27lawsuits the reason is that they have
52:29much more direct controls over people's
52:32uh Behavior so in Anglo Saxon system
52:35because we're so free market we choose
52:37to incorporate these things by using
52:38lawsuits in a more pigouvian process in
52:41Europe they more directly control
52:43people's behavior because they believe
52:45more in a regulatory interventionist
52:47state right now in most of these
52:49lawsuits people end up actually
52:51negotiating and that's what determines
52:52the payment but it's in the shadow of
52:54the legal system tying it down yeah
52:55chrisan uh p a uh payment in accordance
53:00with
53:01product
53:02yeah uh yes well how could you file a
53:05lawsuit unless there was like already a
53:07law regulation preventing activity like
53:09oh that's the common law so the most of
53:12the law in the uh like Anglo-Saxon
53:17system is not based on statutes that
53:20exist in other countries it is but in
53:24the anglosaxon system most of law comes
53:27from
53:28tradition so that's what's the common
53:31law means civil law systems are ones
53:34where Mo everything is written down in
53:37in the law um yeah good point uh I think
53:41we're going to keep going okay so um
53:45instead of uh just putting attack we
53:50might want to put a maximum amount on
53:53how much of the activity takes place and
53:55then allow people people to trade the
53:57right to do that right so you could put
53:59a maximum amount of pollution that's
54:00allowed and then auction or assign
54:02rights to people or if it's a positive
54:06externality you could say that if you
54:09don't have a permit then you have to do
54:11the thing right and that's a way of
54:13creating a positive price for doing the
54:15thing so returning to the smoking
54:17example pagu would want to put a tax of
54:21$9
54:24uh sorry 90 cents per cigarette uh but
54:28alternatively you could cap the total
54:30number of cigarettes at
54:3255,000 and that would make the supply of
54:34cigarettes completely inelastic at
54:3655,000 and therefore the price of
54:39obtaining a permit would be exactly 990
54:43right
54:44um sorry I I already answered this
54:49um so uh so then the price would rise to
54:54$1.90 in order to clear the market and
54:56that would give you exactly the same
54:57thing as would as what would happen with
54:59the tax right so capping at the optimal
55:02quantity is equivalent to putting taxes
55:05and this is true because of the
55:06definition of market optimality right
55:09adding forcing things to be the optimal
55:11quantity will lead the optimal price to
55:14occur right so um this is commonly
55:19proposed for
55:20pollution allowing people to trade
55:23creates a price uh and capping the total
55:25amount of pollution creates a right uh a
55:29price for pollution and if it's set at
55:31the efficient level this is the same as
55:34the tax and it's equivalent for most
55:36intensive purposes the easiest way to
55:38think about this is imagine we had an
55:39auction for the pollution permit right
55:43um then we would the price in that
55:46auction of the rights of the permits
55:48would be exactly the tax and that would
55:50raise the same amount of revenue for the
55:51government everything would be exactly
55:53the same right but it's often proposed
55:56that instead of having attacks then
55:58instead we uh use these permits and it's
56:02not that we're going to hold an auction
56:03where it really would be almost
56:04equivalent instead the reason is people
56:07want to give out the permits to people
56:08who are their political supporters right
56:12so um and this seems a lot more
56:14politically
56:16palatable uh than raising a tax and then
56:19giving out money to people right because
56:21it's sort of hidden the fact that you're
56:22giving out money to people you could
56:24have auctioned the thing
56:26or you could have put the tax but if you
56:28put the tax then you wouldn't be able
56:30politically to give money back to the
56:31industry to buy its support for the tax
56:34whereas if you give them out permits
56:35people said oh that's fair they were
56:36just polluting anyways even though those
56:38are exactly the same thing right
56:42um so uh putting this aside though um is
56:47there an economic logic that might favor
56:50doing one thing or the other uh can you
56:53think of one Mor
57:00I guess that way puts it more like in
57:01the hands of prices rather than like a
57:03centralized thing so you don't really
57:04need too much information too much
57:07centralized information you just need to
57:09know prices well so it
57:12certainly impacts that but remember that
57:14here in order to figure out the right
57:16price we need to know what the optimal
57:17quantity was to figure out the marginal
57:19value at the optimal thing so if we knew
57:22exactly what the marginal value was well
57:24then you're right but what if if we
57:26don't know that what if we know exactly
57:28what the total amount Beyond which the
57:30world blows up is right then you would
57:33clearly want to put a quantity right you
57:35wouldn't want to put a price because it
57:36would require a lot more information to
57:38get the price right right and so let's
57:40go through an analysis of that right the
57:43B basic problem is we might not know
57:45exactly what the demand is for the thing
57:47and like once we set the price or the
57:49quantity that's going to be locked in
57:51for a while before we see what happens
57:53in the market right that's that's
57:55exactly the you were talking about right
57:58now if the marginal cost is very elastic
58:01if the you know if we basically know
58:03what the price should be if we know what
58:04the value is then we should impose a
58:07price right but on the other hand
58:10imagine that like the also sorry also if
58:14the marginal cost of people not doing
58:17the thing is very steep right so like um
58:23imagine that like the market absolutely
58:25has to do a certain amount we don't know
58:27exactly what that amount is but if they
58:29do any little bit less or a little bit
58:31more it's going to be a total disaster
58:32for them it's going to cost them a hum
58:34Mount well then you really wouldn't want
58:35to put a cap on it right because then
58:38you're going to cause a huge Distortion
58:39in what the market
58:41does um in that case you want to use the
58:44tax and that's the case of sort of a
58:47local
58:48externality so for example something
58:51like smoking it only affects the people
58:53right around you it doesn't like add up
58:55over the whole planet so it would be
58:56crazy to put like a cap on the amount of
58:58smoking because it could be really
59:00costly to people uh to do it to like get
59:03off smoking you don't really know
59:04exactly how hard it is for people to get
59:06off smoking and on the other hand it's
59:08not like it's adding up over the whole
59:10world and going to reach some Tipping
59:11Point right you basically know how much
59:13harm it's causing to
59:14people um and that's why most local
59:17externalities use the tort system or the
59:20you know the legal system is that
59:22they're not things that are adding up
59:24over the whole country so it doesn't
59:25make sense to it you just take the harm
59:28and you make people pay for
59:30that uh on the other hand if the optimal
59:34quantity of something is basically
59:36independent of how much people want to
59:38do it because like if we do even a
59:41little bit more than something the whole
59:42world is going to blow up right then um
59:46we clearly want to put a cap on it or if
59:50the amount that it costs people to stop
59:53doing the thing is pretty much constant
59:56um then uh there's not too much waste if
1:00:01we um if we set the quantity slightly
1:00:05wrong right it's not like it's going to
1:00:06get incredibly costly incredibly quickly
1:00:09and so as a result um in those cases
1:00:12we're going to want to put a cap so what
1:00:14what are examples of that well if you
1:00:15think of congestion on a road right if
1:00:18you get even slightly past a certain
1:00:20point like the chance of the road really
1:00:22slowing down is much much much much
1:00:25higher so it makes a lot more sense to
1:00:26put like a cap on the total number of
1:00:28people who can be on a road or like the
1:00:30cap on the total number of people who
1:00:31can be in a cinema at one time rather
1:00:33than just having a price for tickets
1:00:35that clears the market for the cinema
1:00:37right like think if you were a cinema
1:00:38you would never just say like no we
1:00:41don't sell out of the cinema we the
1:00:42price just gets really high and then you
1:00:44have to like pay for standing in the
1:00:46cinema right I mean clearly it gets
1:00:48really congested beyond that point and
1:00:50it's it's harmful right and similarly um
1:00:55you know for lead in gasoline like the
1:00:58amount that it costs you to take the
1:00:59lead out of your gasoline is pretty much
1:01:02totally constant across people right
1:01:04doesn't vary at all it's just given by
1:01:07you know whatever the cost of taking the
1:01:09lead out was on the other hand it can
1:01:12accumulate in the environment and make
1:01:13things worse and so if the optimal
1:01:15quantity we sort of know is zero you
1:01:17just legislate that and you don't um you
1:01:19don't have a taex so uh to give you a
1:01:23picture of this um here's is a case
1:01:27where imagine this is the marginal
1:01:29private benefit and this is the marginal
1:01:31social cost here the marginal social
1:01:33cost is pretty flat the marginal private
1:01:35benefit is very steep if we impose a
1:01:37price we only get a little Distortion
1:01:39which are these little triangles between
1:01:41the price and the true social benefit
1:01:44right
1:01:46um and so actually that's not the right
1:01:50triangle the right triangle is this one
1:01:51here but it's still pretty
1:01:53small um
1:01:56oh no no that is right that is right
1:01:59okay uh so on the other hand the if we
1:02:05impose a quantity control right then we
1:02:08get a huge loss which are these big
1:02:09triangles here because we're moving way
1:02:12away from what would be socially optimal
1:02:14which would be uh over here right on the
1:02:18other hand if the marginal private value
1:02:20is pretty flat and the marginal social
1:02:22cost is really steep if we impose a
1:02:24price control see we get pretty far from
1:02:27what we should be doing which are these
1:02:29points here right but if we oppose a
1:02:33quantity control we get pretty close and
1:02:34therefore we get small triangles and
1:02:36large triangles on the price control uh
1:02:39yes so those DOD lines are like
1:02:40representing the uncertain yeah it's the
1:02:42uncertainty of what might be the demand
1:02:48exactly okay so however all of these are
1:02:52basically like government Le public
1:02:55public solutions to these problems and a
1:02:58natural question is is there some way
1:03:00that the private sector could solve
1:03:02these problems on on its own right um
1:03:05and one argument is that if property
1:03:08rights are clear then people always
1:03:10bargain to efficiency so for example
1:03:12imagine that it's there's just an issue
1:03:14between you and your neighbor right and
1:03:16imagine that your neighbor makes a lot
1:03:17of noise at night and that
1:03:20um and that uh and that you can't sleep
1:03:25as a result now the optimum might be for
1:03:27like you to make some intermediate
1:03:29amount your neighbor to make some small
1:03:31amount of noise that lets you sleep but
1:03:32lets them enjoy themselves right and if
1:03:35either of you has property rights you'll
1:03:38basically figure this out so imagine he
1:03:39has the right to make as much noise as
1:03:41he wants that's his absolute right well
1:03:43you could come in and pay him and say
1:03:44well look it doesn't cost you that much
1:03:46to reduce the amount of noise a little
1:03:47bit it's really valuable to me let me
1:03:49make you a payment on the other hand if
1:03:52he has the right if you have the right
1:03:55have everything be absolutely quiet he
1:03:59could say okay I understand that's your
1:04:00right but let me give you a little
1:04:01payment in order to allow me to Make
1:04:03Some Noise right you can sell him the
1:04:05right to Make Some Noise either way
1:04:07you'll achieve an efficient bargain and
1:04:09basically you'll come to the same
1:04:10bargain regardless of who has the right
1:04:13right so um this has been used to argue
1:04:17uh that we shouldn't do anything about
1:04:19externalities we should just let them
1:04:20solve themselves we should give people
1:04:22the rights to various things and that
1:04:24will take care of it and this this logic
1:04:26is called stigler's Coast theorem or the
1:04:28coast theorem or CO's theorem it says
1:04:30that if there's no transaction cost in
1:04:32inhibiting bargaining then efficiency
1:04:35always results and if the income effects
1:04:37are small if it's a small part of your
1:04:39income then the outcome is independent
1:04:40of the assignment of property rights uh
1:04:43I'm going to be talking Philip what's
1:04:44your question uh hold on are there I'm
1:04:47just wondering about the assumpt if
1:04:49there any other assumptions on this yeah
1:04:51well I mean we're going to talk a bunch
1:04:52about this so yeah um so the real
1:04:55question is what is a transaction cost
1:04:57of bargaining does anyone have a thought
1:04:59and Philip do you want to address that
1:05:01yeah yeah it would just be like if you
1:05:03need to spend time negotiating and you
1:05:05would rather use a time for working for
1:05:07money or Leisure yeah so that's that's
1:05:10one thing but also if you don't know
1:05:13perfectly what the bargain should be if
1:05:16one of you knows and the other doesn't
1:05:18know then you might have some trouble
1:05:20figuring it out I mean basically
1:05:21anything that impedes efficiency is bar
1:05:24is a uh transaction cost so really this
1:05:27is just a taty it says if there's
1:05:29nothing impeding efficiency then
1:05:32efficiency results right so another way
1:05:34of putting this is all is for the best
1:05:36in the best of all possible worlds right
1:05:39nonetheless I think this can be a useful
1:05:40way to think about some things in in
1:05:42some cases yeah Christian real quick so
1:05:45like if property rights weren't clearly
1:05:47defined that would be a transaction cost
1:05:49not really because not really because
1:05:52the thing is like there's always going
1:05:53to be some deao property right which is
1:05:55is basically what will happen absent
1:05:57violence in the situation you know what
1:05:59I mean like even if it's not clear who
1:06:01has the right to do what like you're
1:06:03going to have some thing which is going
1:06:05to be like what'll happen in the absence
1:06:08of some agreement and you just bargain
1:06:09away from that so the state of war is
1:06:13still well I mean this is one problem
1:06:15with the coast theorem right is like you
1:06:17know War should never happen according
1:06:19to the coast theorem because there's
1:06:20always something that will happen and we
1:06:21should always bargain to the efficient
1:06:23peace treaty from any state of War
1:06:26right um okay so bargaining works well
1:06:30when there's a small number of people
1:06:32right who have all the relevant
1:06:34information and who can find one another
1:06:36right um and in particular bargaining is
1:06:40often facilitated by a long-term
1:06:42relationship that facilitates us knowing
1:06:44each other knowing the information we
1:06:46have and so forth so for example a con
1:06:49this Al often happens through some sort
1:06:50of a merger so like a Condominium
1:06:53Association uh is is set up to help
1:06:56people like bargain over what's going on
1:06:58with the you know condo and these people
1:07:00have known each other for a long time
1:07:02they know who who each other are they
1:07:04know what their interests are that may
1:07:05allow them to bargain more easily
1:07:07company towns like Hyde Park uh you know
1:07:10Hyde Park has relationships with like
1:07:12mac properties and with everybody else
1:07:14in the neighborhood and sort of can more
1:07:17easily bargain as a result Cooperative
1:07:19firms are thought to do this so like if
1:07:22they have a relatively small number of
1:07:24workers they in the work workers and the
1:07:26um consumers you know can all sort of
1:07:29know each other bargain with each other
1:07:30Etc European Union some people have
1:07:33argued does this it allows for
1:07:35bargaining between uh people you know
1:07:38within the Union uh they sort of know
1:07:40each other know their interest and they
1:07:42can hopefully bargain to efficient
1:07:43outcomes of course some things don't
1:07:45always work lots of those examples have
1:07:48lots of uh imperfections and there's
1:07:51always still internalities as well right
1:07:54also it's not good if you use a system
1:07:57like this to internalize a pecuniary
1:07:59externality because if you internalize a
1:08:01pecuniary externality that's not a real
1:08:03externality you actually cause real
1:08:05externalities so for example if you have
1:08:07a merger of two competing firms we we
1:08:10said usually firms competition with each
1:08:12other doesn't create a real externality
1:08:14it only creates a pecuniary externality
1:08:16right and if they merge they're going to
1:08:18internalize that pecuniary externality
1:08:20and that creates a real externality of
1:08:22Market power against consumers and
1:08:24Industry wide lobbying group is another
1:08:27example of that you might think that you
1:08:28know lobbying group is internalizing
1:08:30pecuniary externalities on each other
1:08:32because when they Lobby it hurts Whoever
1:08:34has to pay the bills for whatever
1:08:36subsidies they're getting right um
1:08:40another example of this is like a the
1:08:42pack of Mean Girls or you know popular
1:08:45girls at a high school right they might
1:08:47all be conspiring in the dating Market
1:08:49to sort of like exert Market power uh
1:08:52and they're internalizing a pecuniary
1:08:53externality in the example we gave
1:08:55before right rather than a real
1:08:57externality okay so
1:09:01um monopolistic uh sometimes the private
1:09:05sector can at least partially
1:09:06internalize externalities through
1:09:07monopolies and this is often what
1:09:09happens with the provision of uh Network
1:09:12Goods so for example in the fax industry
1:09:15if one firm knew that it would control
1:09:16the fax industry forever it might have
1:09:18an incentive to give those subsidies I
1:09:20was talking about early on because it
1:09:21would know that if the market developed
1:09:23they would be able to cash in on that
1:09:24right so like for example newspapers are
1:09:27often offered free to Consumers to
1:09:30internalize the externality that
1:09:31consumers reading the newspaper has on
1:09:33the people that advertise it right um
1:09:35and this is often useful in the short
1:09:37run especially if the monopolist has a
1:09:39really good sense of whether the market
1:09:41should be created or not of what the
1:09:42externalities are potentially at the
1:09:44equilibrium and it may be worth giving
1:09:46the monopis the right to do that if he
1:09:48has that insight into what the demand
1:09:50patterns really are
1:09:53um but in the long run this can't lower
1:09:56overall price right because the
1:09:57monopolist wants to make a profit um and
1:10:01uh he'll never be willing to do it below
1:10:03cost so a competitive market will often
1:10:07produce at average cost and therefore in
1:10:09the long run the Monopoly will supply
1:10:11less even though it can be useful to get
1:10:13over the hump to give someone a monopoly
1:10:15because they might know what whether
1:10:17it's worth doing that or not okay so
1:10:20despite the potential uh benefits that
1:10:23bargaining can bring and the possib
1:10:25ities of some of these private Solutions
1:10:27I mostly think the coast theorem is
1:10:29misleading and does anyone want to raise
1:10:31some reasons why this idea that you know
1:10:33just leave it to the market is the right
1:10:34response doesn't make a lot of sense uh
1:10:37yeah Austin because there are pretty
1:10:39much all these transaction costs as well
1:10:41as
1:10:42other yeah that's an an important reason
1:10:45uh anyone there's sort of like a
1:10:47complimentary part of that yeah Adam
1:10:49well um one thing is the Assumption of
1:10:51no income effects um well let's put that
1:10:54aside in the moment we're going to put
1:10:56that as yeah also like um the whole idea
1:10:58of information that um both sides need
1:11:01information on what would be but that's
1:11:04sort of part of the transaction cost
1:11:05does anyone else have a yeah Julian well
1:11:07I I guess this is also part of
1:11:08transaction cost but if there's a lot of
1:11:10different people who are hurt by the
1:11:11externality then all of them can't um
1:11:15it's really costly for all of them to
1:11:17individually bargain there's not really
1:11:19any yeah so externalities are sort of by
1:11:21their nature things where lots of people
1:11:23are harmed that's precisely what usually
1:11:25causes externalities and in those cases
1:11:28it's going to be particularly hard to
1:11:29bargain yeah but da do you have well if
1:11:32you have high transaction cost a lot of
1:11:34bargaining won't happen so these ex
1:11:37that's similar to what Austin said does
1:11:38anyone else have a different thing yeah
1:11:40Mike you don't know for sure that any
1:11:43that like every possible bargaining
1:11:45solution will be addressed and you also
1:11:46don't know for sure that whatever
1:11:48preferences people in the bargain reveal
1:11:50are the ones that like they actually
1:11:52want so there could be information yeah
1:11:54so that's a that's an informational
1:11:55issue which is sort of a part of this uh
1:11:58uh in uh yeah Philip uh for it might
1:12:04knowing that this kind of bargaining is
1:12:06going to eventually occur might create
1:12:08very poor incentives maybe someone will
1:12:10turn the music up louder than he wants
1:12:14just so he can extract more payment for
1:12:16yeah so that that's a that's a very good
1:12:18point I think the most basic thing
1:12:20though is that how can it hurt right how
1:12:23can the government intervention hurt if
1:12:24people are going to into efficiency no
1:12:26matter where the property rights are you
1:12:29know if any of these issues matter well
1:12:32then it's going to be beneficial to
1:12:34correct the externality and if none of
1:12:36these issue matter then who cares right
1:12:38you'll always get to efficiency anyways
1:12:40right so the you know it's like it seems
1:12:44completely stupid to say well there's a
1:12:47case where nothing matters at all and
1:12:51let's base policy on that case because
1:12:53in that case any policy is as good as
1:12:55any other policy right so you've got to
1:12:57base policy on the case where things
1:12:58don't work perfectly because that's the
1:13:00only case where it matters what you do
1:13:03right um so the co theorem really says
1:13:07nothing against intervention just like
1:13:08the First Fundamental welfare theorem
1:13:10says nothing against socialism right um
1:13:14so the real externality problem is a
1:13:16problem of information right and this is
1:13:18going to be the theme of our next class
1:13:20the key issue is that information is
1:13:23about these externalities is often
1:13:25either diffused among lots of different
1:13:28people because lots of different people
1:13:30are hurt um in which case it's going to
1:13:33be very hard to get all those people
1:13:34together to bargain or um it's something
1:13:39that's much more accessible to an
1:13:40outside expert who can assess things
1:13:43like what are the effects of acid rain
1:13:45coming from the you know uh climate etc
1:13:49etc and those are people who aren't
1:13:51parties the problem right so most of
1:13:53these externality things are where the
1:13:55parties don't understand the mechanism
1:13:57of the externality or where the effects
1:13:59are diffused and in both of those cases
1:14:01the parties bargaining are not going to
1:14:02have the relevant information right and
1:14:06uh or it's going to be very hard for
1:14:08them to all get together right and the
1:14:10key issue in externality design is how
1:14:12to combine this information coming from
1:14:14expertise that's outside of the people
1:14:17in the thing and how to aggregate the
1:14:19information of lots of different
1:14:20diffused people and that's what the next
1:14:22class is going to be about how do we
1:14:24deal with those problems because we know
1:14:25that the Market deals well with problems
1:14:27when you don't have these outside
1:14:29experts and you don't have the um you
1:14:32don't have the uh problem of so many
1:14:35different people all being affected by
1:14:37things um and simplistic answers like
1:14:41the coast theorem what are do a good job
1:14:43of explaining why markets work and they
1:14:45do a very poor job in these cases where
1:14:47we know markets can't work because it's
1:14:50important to get these centralized
1:14:52information or to aggregate information
1:14:55from large numbers of people and the
1:14:57next class is going to sort of G you
1:14:59against that sort of naive response and
1:15:01try to get you to think in a more
1:15:02detailed way about how to set up these
1:15:05systems now we have a few extra minutes
1:15:07I there's tons of questions earlier I
1:15:09don't know if anyone wants to ask a
1:15:10question
1:15:11now yeah Austin So like um with with the
1:15:16coast theorem does things like social
1:15:19taboos fit into the whole transaction
1:15:21costs or is that a separate
1:15:23thing like you know or donations you can
1:15:26come up with all sorts of you know well
1:15:28I think it fits in um only if there's a
1:15:31way that the government can solve that
1:15:33better so I think sometimes there is a
1:15:35way that the government can solve that
1:15:36better because of information problems
1:15:38so like let me give you an example
1:15:39remember we talked about the case that I
1:15:41thought like in a lot of medical
1:15:42Innovation you get you know stuck in
1:15:45this thing with you know your dying
1:15:47parents who think that if you don't
1:15:50force them to stay alive that you don't
1:15:52love them well the government coming in
1:15:53and just putting in death panels can
1:15:55solve that because now you have no
1:15:57choice right and there was this
1:15:58information problem before where your
1:16:00parents didn't know whether you love
1:16:01them or not you see what I mean and
1:16:03that's this like when there's an
1:16:05information problem like that some
1:16:06intervention by the government can
1:16:08potentially solve
1:16:11that any anybody
1:16:14else uh D yeah can we go back like one
1:16:17or two slides
1:16:19yeah yeah
1:16:25oh yeah here um inter what exactly does
1:16:28it mean to internalize externalities to
1:16:31could you go through that example again
1:16:32I think yeah so imagine that like um so
1:16:38imagine that no one could make profits
1:16:41off of
1:16:42newspapers uh then it would be very hard
1:16:47like newspap no one would give
1:16:48newspapers way for free because they
1:16:49would all be charged the price that it
1:16:52cost to print them right but because
1:16:55people can make profits off of the
1:16:56advertisers they have an incentive to
1:16:58give them away free to Consumers and
1:16:59that might be better because there might
1:17:01be externalities to advertisers of
1:17:03having consumers read the newspaper and
1:17:05therefore see the ads and and like the
1:17:08market power the you know Monopoly that
1:17:10the newspaper can have over that
1:17:12newspaper actually gets them to
1:17:13internalize that externality maybe even
1:17:15charge less to the consumers than uh a
1:17:18market would you see what I mean when
1:17:20you say internalize it means it takes
1:17:22into account that next yes exactly okay
1:17:25yeah yeah this is an earlier question
1:17:27when you were talking about um basically
1:17:29multiplying damages caused by particular
1:17:32action by the probability hitting it
1:17:33doesn't um doesn't that basically just
1:17:36encourage people to be good
1:17:38criminals like if you're above average
1:17:40you still have a net positive return to
1:17:42no you don't multiply it you divide it
1:17:44divide it so in other words like you
1:17:46divide it by the probability of getting
1:17:47caught right because that makes you if
1:17:50you're a good criminal if there's like a
1:17:53reason to believe that you would have
1:17:55have been unlikely to get caught then
1:17:57you have to pay a huge cost conditional
1:18:01on getting caught so thinking about like
1:18:03the fines for that the government's
1:18:05beening at banks for like money lering
1:18:07and stuff recently yeah so if it's hard
1:18:08to catch the thing if the government
1:18:10thinks like we caught this but it was
1:18:12sort of really difficult to catch it
1:18:13then you have to play a much bigger
1:18:15multiple of how much damage you actually
1:18:16cost that's the idea so it's exactly to
1:18:19discourage people from being good
1:18:21criminals uh yeah um so for the oil
1:18:24spill
1:18:25slide um you mentioned like physical
1:18:28damages are the actual externalities so
1:18:30does that mean the the people who face
1:18:32like a pure economic law shouldn't get
1:18:34compensated that's the idea in the
1:18:35common law
1:18:37yeah and the reason is that the common
1:18:39law even though it comes out of you know
1:18:41years of developing and intuitions and
1:18:44whatever actually deals with these
1:18:47principles of social optimality at least
1:18:51one hopes and there's a whole literature
1:18:52on how the common law developed that
1:18:58way uh Philip yeah in the paper about
1:19:02the car efficiency standards how did
1:19:04they estimate the discount R rate of a
1:19:08representative
1:19:09consumer uh oh it's very complicated I
1:19:13mean they used there's all sorts of
1:19:15assumptions that they made in that paper
1:19:16to get all that stuff out you'll find in
1:19:19most economics papers when they come out
1:19:20with some like sharp conclusion like
1:19:22that usually there's like a million
1:19:25things that they had to assume or take
1:19:27values from other places and so forth to
1:19:30come up with that and you'll have to do
1:19:31that too if you want to have a thesis
1:19:33that comes out with a sexy conclusion
1:19:35like that
1:19:37so usually you can only do something
1:19:40very very sort of like not interesting
1:19:42if you just go with the data directly
1:19:45and to get more sexy conclusions like
1:19:46this you need to make further stronger
1:19:48assumption
1:19:51so okay guys thanks I hope the problem
1:19:54set was okay

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