Property rights, Externalities

and Environmental Problems

Lecture 3

1
Property rights
 Recall steel factory for waste disposal & salmon
fishery problem - key question:
 Who has a grievance, the factory owner or fishers?
 Boils down to:
 who has the initial right to use the services of the lake:
who owns the property rights to the lake.
 A property right is an entitlement gives the holder
exclusive rights to do what he/she wishes with
the property owned.
 It confers on the rights owner the right to enjoy
the flow of benefits from the property.

2
Property rights
 In general, holders of property rights to an
asset have strong incentives to see to it
that it is managed to max. value.
 To solve the externality problem in our
example, specify clearly who has the rights
of ownership to the lake.
 Economists argue that the misuse of many
environmental assets comes about
because of imperfectly specified private
property rights in those assets.

3
 Property rights & social
efficiency
A well-defined or efficient property right will be:
 Excusive: all benefits and costs accrue only to

the owner.
 Transferable: property rights can be exchanged

voluntarily.
 Enforceable: property rights cannot be

encroached on by others.

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 Property rights & social
efficiency
With a well-defined property right resources are
allocated efficiently and both the consumer
surplus and producer surplus (net benefits) are
maximized:
 Consumer surplus is willingness to pay minus
the actual payment or the area under the
demand curve and above the price line.
Consumers will decide how much to purchase
by maximizing his or her own individual benefit.

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FIGURE 2.4 Market Equilibrium

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 Property rights & social
efficiency
 Producer surplus is the area above the
marginal cost (supply) curve and below the price
line. This is the net benefit received by the
seller.
 Net benefit equals the sum of consumer and
producer surplus. The market allocation will
maximize net benefits. If net benefits are not
maximized, the allocation is inefficient.
 Lack of property rights leads to externalities

7
 Externalities as a Source of
Market Failure
 Market failure can be caused by property rights that
fail to achieve exclusivity, transferability or
enforceability. If an agent making a decision does
not bear all of the consequences (costs and
benefits) of that decision, then the characteristic of
exclusivity is violated. This causes what is called an
externality.
 Externalities or third party effects exist
whenever an agent’s activities affect another
agent’s welfare.
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 Externalities as a Source of
Market Failure
 An external diseconomy or negative
externality imposes costs on a third party. An
example of a negative externality is a steel mill
upstream from a fish hatchery.
 An external economy or positive externality
occurs whenever an activity imposes benefits on
a third party. Classic examples of positive
externalities include the external benefits from
vaccines or education.

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FIGURE 2.5 The Market for Steel

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 Pollution Externalities and
Market allocations
 Using Fig 2.5, a number of conclusions can be
drawn about market allocations causing
pollutions externalities:
 The output of the commodity is too large
 To much pollution is produced
 The prices of the polluting products are too low
 No incentive to search for pollution efficiency
 No incentive for recycling, because dumping is
inefficiently cheap!
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 Incentives and Property Right
Systems
There are four general property rights regimes that
create different incentives for resource use (or
misuse).
 Under private property regimes, individuals hold
entitlements.
 Under state-property regimes, governments own and control
property (e.g. some parks and forests).
 Common-property regimes are those in which property is
jointly managed (local fisheries)
 Under open access regimes, no one owns or exercises
control over the resources. This type of regime leads to the
“tragedy of the commons” because they can be exploited
by whoever can get them first. 12
 Public Good:
Public goods are both indivisible and nonexcludable.
Indivisibility means that one person’s consumption
does not affect another’s. Nonexcludability means
that persons cannot be kept from enjoying the
benefits of a good even if they do not pay for it.
Clean air, national defense and biological diversity
are all examples of public goods.
 Public goods will be underprovided in a private

market because of free-riders.

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 Imperfect Market Structure
Environmental problems also occur when one of the
participants in an exchange of property rights is able
to exercise market power- monopoly.
 Monopolies will supply too little of a good at too

high a price (Fig. 2.8). A cartel, OPEC, for example,

colludes in order to gain monopoly power.
Restricting output, raises the price of oil.
 At the monopoly output, marginal benefits are

greater than marginal costs. Net benefits are not

maximized and there is a deadweight loss.

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FIGURE 2.8 Monopoly and
Inefficiency

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 Government Failure
Governments, similarly to markets, can also be
sources of inefficiency.

 Rent seeking behavior may persuade government

officials to pursue options that are beneficial to a
specific interest group and that do not maximize
social net benefits. Agricultural producers seeking
price supports is an example of rent seeking.
Consumer groups may seek subsidies.

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 The Pursuit of Efficiency
What ca be done?
 Private resolution through negotiation is the

simplest means of restoring efficiency. For example,

a downstream firm hurt by an upstream polluter
could negotiate or bribe the upstream to reduce
pollution (Fig 2.10).
 Property rights that are not well-defined and lead to

inefficiencies can be corrected by a court system

which imposes either property rules or liability
rules. Examples relevant to the upstream polluter
example include discharge permits.
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Figure 2.10: Efficient Output with Pollution
Damage

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 The Pursuit of Efficiency
 The Coase Theorem says that when negotiation
costs are negligible and affected parties can freely
negotiate, the entitlement can be allocated by the
courts to either party and an efficient allocation will
result. Only the distribution of costs and benefits
among the effective parties is changed. Regardless
of which party the property right is assigned to, an
efficient level of production will result.

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Coase Theorem

 When negotiation costs are negligible and

affected parties can freely negotiate, the
entitlement can be allocated by the courts to
either party and an efficient allocation will
result. Only the distribution of costs and
benefits among the effective parties is
changed.

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 The Pursuit of Efficiency
 Legislative and executive regulation are remedies
that can take several forms including taxes and
regulatory laws. Gasoline taxes and regulations on
unleaded fuels are potential discussion topics as are
proposals for carbon taxes.
  

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Summary

 Property rights
 Externalities
 Improperly defined property rights system
 Imperfect markets
 Rent seeking

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