Externalities and Property Rights

Key Terms:

Externality
Property rights
Transaction costs
Cost/benefit analysis
Tragedy of the commons

Lesson Objectives

Externalities, also know as spillovers or neighborhood effects, are any costs or benefits of production and exchange that are not taken into account by those who create the costs or benefits. Examples of positive externalities include the benefits to passersby of a beautiful garden on a busy street, or the safer neighborhood for others that results from some residents hiring private security patrols. Examples of negative externalities include an unmowed lawn in a suburban neighborhood, or automobile exhaust, or second-hand cigarette smoke. Cooperation becomes more difficult and markets operate less efficiently when externalities exist, because individuals have no incentive to take into account the consequences of their actions for other people.

The "Tragedy of the commons" refers to the lack of incentive to husband resources (like fish in a public lake) that are owned by everyone, and thus by no one (until they are caught). Defining property rights more satisfactorily enables market processes to encourage productive cooperation instead of waste and conflict, as is demonstrated by the case of the African elephant or the use of pollution tax credits to reduce sulfur-dioxide emissions.

Compare situations where a tragedy of the commons exists to situations in which property rights are clearly defined and well-secured.

1. Consider the typical high school cafeteria. Why are most of the tables dirty and surrounded by trash, while the senior section is relatively clean?

2. Why is there graffiti on the walls of the school bathrooms, but not on the walls of your bathroom at home?

3. Why do you suppose that there are many people moving freely around the park, there is little visible trash, and the bathrooms are clean at Disney World, while at Yellowstone National Park, roads are congested and trash barrels often overflow?

Definitions

Cost/benefit analysis - A comparison of the costs and benefits of a choice in an effort to select alternatives that maximize the difference between benefits and costs.

Externalities - The cost and/or benefits that are not internalized by the processes of production and exchange, and which therefore spill over onto third parties. Externalities may be positive or negative. (Also known as spillovers or neighborhood effects.)

Property rights - The conditions of ownership, including the rights and restrictions regarding use, ownership, and sale.

Tragedy of the commons - Describes the phenomenon of overuse of resources held in common (i.e. by the "public" or by government) that occurs because the failure to adequately define property rights means that no one has an incentive to conserve or maintain the resource and all have an incentive to use the resource before others do.

Transaction costs - The resources (like time and energy) that are used in making an exchange. An example of a transaction cost is time spent shopping or the time and energy necessary to negotiate a contract.