Chapter 10: Externalities

and Property Rights

1
©2015 McGraw-Hill Education, All Rights Reserved
 Learning Objectives

1. Define negative and positive externalities and

analyze their effect on resource allocations
2. Explain how the effects of externalities can be
remedied
3. Compare and contrast the ways in which taxes
and tradable permits can be used to reduce
pollution
4. Discuss why the optimal amount of an
externality is not zero
5. Characterize the tragedy of the commons and
show how private ownership is a way of
preventing it

2
©2015 McGraw-Hill Education, All Rights Reserved
 External Costs and Benefits

n External cost is a cost of an activity that is

paid by people other than those who
pursue the activity
Ø Also called a negative externality

n External benefit is a benefit of an activity

received by a third party
§ Also called a positive externality

n Externality an external cost or benefit of

an activity
3
©2015 McGraw-Hill Education, All Rights Reserved
 Externalities

n This chapter focuses on how externalities affect

the allocation of resources
n Adam Smith’s theory of invisible hand applies
to an ideal market, in which externalities do not
exist
Ø In an ideal market, self-interested actions of
individuals would lead to socially efficient
outcomes

n In the case of externalities, when the parties

affected can easily negotiate with one another,
the invisible hand will still produce an efficient
outcome
4
©2015 McGraw-Hill Education, All Rights Reserved
 Externalities Affect Resource Allocation

n Externalities reduce economic efficiency

Ø Solutions to externalities may be efficient
Ø When efficient solutions to externalities are
not possible, government intervention or
other collective action may be used

5
©2015 McGraw-Hill Education, All Rights Reserved
 Honeybee Keeper – Scenario 1

n Asal harvests and sells honey from her bees

Ø Herneighbors grow apples
Ø Bees pollinate their apple orchards

n The bees provide a free service to the local

farmers
Ø Asal is giving away a service
§ No payments made to Asal
§ If Asal takes only her own costs and benefits into
account in deciding how many hives to keep, will she
keep the socially optimal number of hives?

6
©2015 McGraw-Hill Education, All Rights Reserved
 Honeybee Keeper – Scenario 1

n The bees provide a free service to the local

farmers
Ø Since the orchard owners also benefit from additional
hives, the total benefit of adding another hive at that
point will be greater than its cost
§ Private costs are equal to private benefits
• Asal, then, will keep too few hives
§ Social costs are less than social benefits

When external benefits exist,

maximizing private profits produces less
than the social optimum

7
©2015 McGraw-Hill Education, All Rights Reserved
 Honeybee Keeper – Scenario 2

n Asal harvests and sells honey from her bees

n Neighboring school and nursing homes are
bothered by bee stings
n The bees are a nuisance to the neighbors
Ø Asal is not paying all the costs of her honeybees
§ Private costs are equal to private benefits
• Social costs are greater than social benefits

When external costs exist,

maximizing private profits produces more
than the social optimum

8
©2015 McGraw-Hill Education, All Rights Reserved
 How Do Externalities Affect Supply /
Demand?

No External Cost External Cost

Price ($000s / ton)

Social MC

Price ($000s / ton)

Private
2.3 $1,000/ton
MC
2.0
1.3 Private
1.3 MC
D
12,000 D
Quantity (tons/year)
8,000 12,000
Quantity (tons/year)

Deadweight loss from Social Private

pollution = $2 M/yr Optimum Equilibrium
9
©2015 McGraw-Hill Education, All Rights Reserved
 How Do Externalities Affect Supply /
Demand?

n Since the external pollution cost falls not on

firm owners but on others who live
downwind from their factories,

n Private MC is still the supply curve for this

product, and its demand curve is again as
before,

n So the equilibrium price and quantity will be

exactly the same as the one represented by
the left graph
10
©2015 McGraw-Hill Education, All Rights Reserved
 How Do Externalities Affect Supply /
Demand?

n But this time the private market equilibrium is

not socially optimal

n As before, the market equilibrium level of output

is 12,000 tons per year

n However at that output level, the value to

consumers of the last unit of output produced is
only $1,300 per ton, while the true cost of
producing that last unit (including the external
cost) is $2,300 per ton
11
©2015 McGraw-Hill Education, All Rights Reserved
 How Do Externalities Affect Supply /
Demand?

n This means that society could gain additional

economic surplus by producing fewer units of the
product
Ø The same conclusion will continue to hold whenever
the current output exceeds 8,000 (where demand
curve intersects Social MC)
n As output expands past 8,000, the marginal cost
of each successive unit (as measured on the
Social MC curve) is greater than the marginal
benefit of that unit (as measured on the demand
curve)
Ø This entails a reduction in total economic surplus
§ Deadweight loss from pollution is $2 million

12
©2015 McGraw-Hill Education, All Rights Reserved
Positive Externality for Consumers

Deadweight loss from

positive externality
XB
MBPVT + XB
MC
Price

MBSOC
MBPVT
Social
Demand

Private Demand
QPVT QSOC
Private Social
Equilibrium Quantity Optimum

13
©2015 McGraw-Hill Education, All Rights Reserved
 How Do Externalities Affect Supply /
Demand?

n To summarize,
Ø Whether externalities are positive or
negative distort the allocation of resources
in efficient markets

Ø When externalities are present, the

individual pursuit of self-interest will not
result in the largest possible economic
surplus

Ø The outcome is thus inefficient

14
©2015 McGraw-Hill Education, All Rights Reserved
 Effects of Externalities

With externalities,
private market outcomes
do not achieve
the largest possible economic surplus

Cash is left on the table

15
©2015 McGraw-Hill Education, All Rights Reserved
 Remedying Externalities

n With externalities, private market

outcomes do not achieve the largest
possible economic surplus
Ø Cash is left on the table
n For example, with monopolies, output is
lower than with perfect competition
Ø Introduction
of coupons and rebates
expands the market
n With externalities, actions to capture the
surplus are likely
16
©2015 McGraw-Hill Education, All Rights Reserved
 The Coase Theorem

n To say that a situation is inefficient means

that it can be rearranged in a way that
would make at least some people better
off without harming others
n The existence of inefficiency means that
there is cash on the table, which usually
triggers a race to see who can capture it
Ø Forexample, because monopoly pricing
results in an inefficiently low output level, the
potential for gain gave monopolists an
incentive to make discounts available to price-
sensitive buyers

17
©2015 McGraw-Hill Education, All Rights Reserved
 The Coase Theorem

n If people can negotiate the right to perform

activities that cause externalities, they can
always arrive at efficient solutions to
problems caused by externalities
Ø Negotiations must be costless
§ Sometimes those harmed pay to stop pollution
§ Sometimes polluter buys the right to pollute
n The adjustment to the externality is usually
done by the party with the lowest cost

18
©2015 McGraw-Hill Education, All Rights Reserved
 The Coase Theorem

n Coase theorem if at no cost people can

negotiate the purchase and sale of the
right to perform activities that cause
externalities, they can always arrive at
efficient solutions to the problems
caused by externalities

19
©2015 McGraw-Hill Education, All Rights Reserved
 Fawaz the Polluter – Scenario 1

n Fawaz’s company dumps toxic waste in

the river
Ø Samer cannot fish from the river
Ø No one else is harmed

n Fawaz could install a filter to remove the

harm to Samer
Ø Filter imposes costs on Fawaz
Ø Filter benefits Samer

n Parties do not communicate

20
©2015 McGraw-Hill Education, All Rights Reserved
 Fawaz’s Filter Options

With Filter Without Filter

Fawaz's Gains $100 / day $130 / day

Samer's Gains $100 / day $50 / day

Total Gains $200 / day $180 / day

§ Fawaz does not install the filter

§ Marginal cost of filter to Fawaz is $30 per day
§ The marginal benefit to Samer is $50 per day
§ There is a net welfare loss of $20 per day
21
©2015 McGraw-Hill Education, All Rights Reserved
 Fawaz the Polluter – Scenario 2

n Communications (at no cost) changes the outcome

Ø Samer pays Fawaz between $30 and $50 per day to use the
filter
Ø Net gain in total surplus of $20 per day
Ø Installing filter net gain: Fawaz (100-130=-30), Samer
(100-50=50)
Ø Samer pays $30 è net gain: Fawaz (30-30=0), Samer
(50-30=20)

With Filter Without Filter

Fawaz’s Gains $100 / day $130 / day

Samer’s Gains $100 / day $50 / day

Total Gains $200 / day $180 / day

22
©2015 McGraw-Hill Education, All Rights Reserved
 Fawaz the Polluter – Scenario 3

n Fawaz’s company produces toxic waste

Ø Laws prohibit dumping waste in the river
UNLESS Samer agrees
Ø New gains matrix

With Filter Without Filter

Fawaz's Gains $100 / day $150 / day

Samer's Gains $100 / day $70 / day

Total Gains $200 / day $220 / day

23
©2015 McGraw-Hill Education, All Rights Reserved
 Fawaz the Polluter – Scenario 3

n Fawaz can pay Samer up to $50 per day for the

right to pollute
Ø Samer will accept any offer over $30 per day
n If Samer accepts $40, then total gain is $220
($110+$110)
n In this scenario, polluting is the right thing to do

With Filter Without Filter

Fawaz's Gains $100 / day $150 / day

Samer's Gains $100 / day $70 / day

Total Gains $200 / day $220 / day

24
©2015 McGraw-Hill Education, All Rights Reserved
 Price Incentives and the Environment

n Goods with negative externalities tend to

be overproduced
n Suppose that the social objective is to
reduce pollution by half from its
unregulated level
Ø Themost efficient solution is one where the
marginal cost of pollution abatement is the
same for all polluters
§ Cost data are not available to government
Ø One solution is to have all reduce pollution by
the same proportion
§ Uneven distribution of costs

25
©2015 McGraw-Hill Education, All Rights Reserved
 Price Incentives and the Environment

n One policy option is to tax pollution

Ø Businesses decide how much pollution to produce
n 2 firms, 5 production processes each
Ø Production differs by cost and amount of pollution
Cost of Production and Amount of Smoke Emitted

Process A B C D E
(smoke) (4 T/day) (3 T / day) (2 T/day) (1 T/day) (0 T/day)
Sludge Oil
$100 $200 $600 $1,300 $2,300
($/day)
NW Lumber
$300 $320 $380 $480 $700
($/day)
T = ton

26
©2015 McGraw-Hill Education, All Rights Reserved
 Price Incentives and the Environment

n If there are no regulations, each firm

produces at its lowest cost, production
method A
Ø Each firm produces 4 tons of smoke per day
n Government wants to cut pollution by half
Ø Option 1: Set maximum pollution limits
Ø Option 2: Tax smoke at a rate of $T per ton
§ Determine T to reduce pollution by half
n Each option has costs to society that must
be considered
27
©2015 McGraw-Hill Education, All Rights Reserved
 Option 1: Reducing Pollution by
Regulation

n Each firm moves to production process

C
Ø Costs increase $500/day for Sludge and
$80/day for NW Lumber
§ Total cost to society of this plan is $580/day
Cost of Production and Amount of Smoke Emitted

Process A B C D E
(smoke) (4 T/day) (3 T / day) (2 T/day) (1 T/day) (0 T/day)
Sludge Oil
$100 $200 $600 $1,300 $2,300
($/day)
NW Lumber
$300 $320 $380 $480 $700
($/day)

28
©2015 McGraw-Hill Education, All Rights Reserved
 Option 2: Taxing Pollution

n If tax is $T per ton, the firms will reduce pollution as

long as the cost of reductions is less than $T
n A tax of $101 moves Sludge to B and NW Lumber to D
n Total cost is $100 for Sludge + $180 for NW = $280/
day
Ø Net savings of $300/day over regulation ($580 - $280)

Cost of Production and Amount of Smoke Emitted

Process A B C D E
(smoke) (4 T/day) (3 T / day) (2 T/day) (1 T/day) (0 T/day)
Sludge Oil
$100 $200 $600 $1,300 $2,300
($/day)
NW Lumber
$300 $320 $380 $480 $700
($/day)
29
©2015 McGraw-Hill Education, All Rights Reserved
 Price Incentives and the Environment

n Taxing pollution concentrates pollution

reduction in firms that can accomplish it at the
least cost
Ø Cost – Benefit Principle
Ø Cost of the last ton of smoke removed is the same
for all firms
n It can be difficult to determine the optimal tax
rate
Ø Set the tax too high and you get too little pollution
Ø Set the tax too low and you get too much pollution
§ Marginal cost exceeds marginal benefit to society

30
©2015 McGraw-Hill Education, All Rights Reserved
 Option 3: Auctioning Pollution Permits

n Set a target level for total pollution allowed

Ø Auction 4 permits to allow 4 tons/day
n Determine price of a permit, who buys
them, and the total cost of pollution
reductions

Cost of Production and Amount of Smoke Emitted

Process A B C D E
(smoke) (4 T/day) (3 T / day) (2 T/day) (1 T/day) (0 T/day)
Sludge Oil
$100 $200 $600 $1,300 $2,300
($/day)
NW Lumber
$300 $320 $380 $480 $700
($/day)
31
©2015 McGraw-Hill Education, All Rights Reserved
 Auctioning Pollution Permits

Cost of Production and Amount of Smoke Emitted

Process A B C D E
(smoke) (4 T/day) (3 T / day) (2 T/day) (1 T/day) (0 T/day)
Sludge Oil
$100 $200 $600 $1,300 $2,300
($/day)
NW Lumber
$300 $320 $380 $480 $700
($/day)

Benefit of Permits
# permits 1 2 3 4
Sludge Oil ($/
$1,000 $700 $400 $100
day)
NW Lumber ($/
$220 $100 $60 $20
day)

32
©2015 McGraw-Hill Education, All Rights Reserved
 Auctioning Pollution Permits

n At a price of $90, 6 permits are demanded

Ø 4 for Sludge Oil and 2 for NW Lumber
n At a price of $101, 4 permits are
demanded
Ø 3 for Sludge Oil and 1 for NW Lumber
n Sludge uses process B and NW uses
process D
# permits 1 2 3 4
Sludge Oil ($/
$1,000 $700 $400 $100
day)
NW Lumber ($/
$220 $100 $60 $20
day)

33
©2015 McGraw-Hill Education, All Rights Reserved
 Advantages of the Auction

n Utilizes low cost pollution control

Ø Permit fees can offset other taxes
Ø Total cost same as with tax; administratively simple
n Predictable operating and investing environment
n Citizens can lobby government to set target
pollution
Cost of Production and Amount of Smoke Emitted

Process A B C D E
(smoke) (4 T/day) (3 T / day) (2 T/day) (1 T/day) (0 T/day)
Sludge Oil
$100 $200 $600 $1,300 $2,300
($/day)
NW Lumber
$300 $320 $380 $480 $700
($/day)
34
©2015 McGraw-Hill Education, All Rights Reserved
 Shared Living

n Dunia and Leena are evaluating housing options

Ø 2-bedroom apartment for $600 per month OR
Ø 2 1-bedroom apartments for $400 per month each
n If the rents were the same, Dunia and Leena
would be indifferent between the two
arrangements
Ø Except, Dunia talks constantly on the phone
§ Dunia would pay up to $250 per month to be able to use the
phone whenever she wants
§ Leena would pay up to $150 per month to get better phone
access
Ø No second phone line is possible
§ Should they live together?

35
©2015 McGraw-Hill Education, All Rights Reserved
 Benefits and Costs of Shared Living

§ Live together if the benefits exceed the costs

Total Cost of Separate Total Cost of Rent Savings

Apartments Shared Apartment from Sharing
$800 per month $600 per month $200 per month

Dunia's Cost of Leena's Cost of

Least-Cost
Problem Solving the Solving the
Solution
Problem Problem
Leena
Restricted phone Tolerate phone tolerates
Dunia's
usage: $250/ usage: $150/ Dunia’s phone
phone usage
month month usage: $150/
month 36
©2015 McGraw-Hill Education, All Rights Reserved
 Net Benefit of Shared Living

Cost of Phone
Rent Savings Gain in Surplus
Accommodation
$200 per month $150 per month $50 per month

n Dunia and Leena will live together J

n Doesn’t this mean that Leena would
end up paying $450 towards the rent,
leaving Dunia with only $150?
37
©2015 McGraw-Hill Education, All Rights Reserved
 Dividing the Rent

n Leena would spend $400 per month to live

alone
Ø The cost of tolerating Dunia's phone use is
$150 per month
Ø The highest monthly rent she would be willing
to pay for the shared apartment is $400 - $150
= $250
n Dunia is willing to pay up to $400 per
month, the cost of living alone
Ø Butthe difference is $350 which is better than
paying $400 to live alone
38
©2015 McGraw-Hill Education, All Rights Reserved
 When Are Legal Remedies for
Externalities Needed?

n If negotiation is costless, the party with

the lowest cost usually makes the
adjustment
Ø Private solution is generally adequate

n When negotiation is not costless laws

may be used to correct for externalities
Ø Theburden of the law can be placed on
those who have the lowest cost
39
©2015 McGraw-Hill Education, All Rights Reserved
 When Are Legal Remedies for
Externalities Needed?

n A motorist with a noisy muffler imposes

costs on others
Ø Yet we cannot flag him down and offer him a
compensation payment to fix his muffler
Ø In recognition of this difficulty, most
governments simply require that cars have
working mufflers
§ A large share of laws is to solve problems caused
by externalities
§ The goal of such laws is to help people achieve the
solutions they might have reached had they been
able to negotiate with one another

40
©2015 McGraw-Hill Education, All Rights Reserved
 Examples of Legal Remedies for
Externalities

n Noise regulations (cars, parties, honking

horns)
n Most traffic and traffic-related laws
Ø Car emission standards and inspections
n Zoning laws
n Building height and footprint regulations
(sunshine laws)
n Air and water pollution laws
41
©2015 McGraw-Hill Education, All Rights Reserved
 Three Cases

Free Speech Planting Trees

§Free speech laws § Government subsidizes
recognize the value of trees on private property
§ Decreases chances of
open communications
flooding and landslides
§ Hard to identify speech
§ Net reduction of CO2 in
that has a net cost the atmosphere
§Some limitations Basic Research
§ Yelling "fire" in a
§ Millions of dollars spent
crowded theatre
by federal government
§ Promote the violent
yearly
overthrow of a
government § Externalities of new
knowledge
42
©2015 McGraw-Hill Education, All Rights Reserved
 Optimal Amount of Negative Externalities

n As pollution is reduced
Ø The marginal benefit from its reduction tends to fall
(diminishing marginal utility)
Ø The marginal cost from its reduction tends to
increase (Low-Hanging-Fruit Principle)
n As a result, the marginal cost and marginal
benefit curves almost always intersect at less
than the maximum amount of pollution reduction
Ø The intersection of the two curves marks the socially
optimal level of pollution reduction
§ This implies the existence of a socially optimal level of
pollution, and that level will almost always be greater than
zero

43
©2015 McGraw-Hill Education, All Rights Reserved
Optimal Amount of Negative Externalities

MC & MB
MC

MC = MB Optimal amount
of pollution

MB

Q
Quantity of Pollution

44
©2015 McGraw-Hill Education, All Rights Reserved
Optimal Amount of Negative Externalities

n But to speak of a socially optimal level of

pollution is not the same as saying that
pollution is good
Ø It
is to recognize that society has an interest
in cleaning up the environment, but only up to
a certain point
§ Think of your apartment
• You can spend the whole day cleaning
• Or you can tolerate some amount of dirt

45
©2015 McGraw-Hill Education, All Rights Reserved
 Taxing a Negative Externality

No Pollution Tax Pollution Tax

$1,000 / ton
Private MC + Tax

Price ($000s / ton)

Social MC
Price ($000s / ton)

2.3 XC Tax
2.0 2.0
Private Private MC
1.3 MC 1.3

D D

8,000 12,000 8,000 12,000

Quantity (tons/year) Quantity (tons/year)

Social Private After Tax Before Tax

Optimum Equilibrium Equilibrium Equilibrium
46
©2015 McGraw-Hill Education, All Rights Reserved
 Taxing a Negative Externality

n Critics insist that taxes always reduce

economic efficiency
Ø This tax actually makes the economy more
efficient
Ø The tax forces producers to take explicit account
of the fact that each additional unit of output they
produce imposes an external cost of $1,000 on
the rest of society
n Similar reasoning suggests that a subsidy to
producers can serve to counteract
misallocations that result from positive
externalities
47
©2015 McGraw-Hill Education, All Rights Reserved
 Subsidizing a Positive Externality

No Subsidy Subsidy

MC Subsidy MC

Price ($ / ton)
Price ($ / ton)

XB
14 14
10 10
Social Subsidized
8 Demand 8 Demand
Private Private
Demand Demand
12 16 12 16
Quantity Quantity
(000s tons/year) (000s tons/year)

48
©2015 McGraw-Hill Education, All Rights Reserved
 Property Rights and the Tragedy of The
Commons

n People who grow up in industrialized

nations tend to take the institution of
private property for granted
Ø Our intuitive sense is that people have the
right to own any property they acquire by
lawful means and to do with that property as
they see fit

n When use of a communally owned

resource has no price, the costs of using it
are not considered
Ø Use of the property will increase until MB = 0
49
©2015 McGraw-Hill Education, All Rights Reserved
 The Tragedy of The Commons

n Suppose 5 villagers own land suitable for

grazing
Ø Each can spend $100 for either a steer or
invest in a risk-free market that pays 13%
§ Steers graze on the commons for 1 year before
being sold in year 2
§ Value of the steer in year 2 depends on the weight
it gained which depends on herd size
Ø Villagers make sequential decisions

50
©2015 McGraw-Hill Education, All Rights Reserved
 Payoff For a Steer

n Using the information in the table below, each

villager makes a decision
# Steers Selling Price per Steer in Year 2 Income per Steer
1 126 26
2 119 19
3 116 16
4 113 13
5 111 11
n The 4th is indifferent between the two assets à
buys a steer
n The 5th invests in the risk-free market
51
©2015 McGraw-Hill Education, All Rights Reserved
 The Tragedy of The Commons

n Since the first 4 villagers will send their steer to

graze, their income becomes 4 x 13 = $52
n The 5th villager will invest in a risk-free market and
earn $13
Ø Total income of the village is $65
n Has Adam Smith’s invisible hand produced the most
efficient allocation of these villagers’ resources?
Ø It has not since their total village income is $65—
precisely the same as it would have been had the
possibility of cattle raising not existed

n What if now villagers make their decision as a

group?

52
©2015 McGraw-Hill Education, All Rights Reserved
 What the Villagers Did

n This time the villagers’ goal is to maximize the

income received by the group as a whole

n Net income from the risk-free investment after

one year is $13
§ Buy a steer only if its marginal benefit is at least $13

n First villager buys a steer and all others invest

in the risk-free market.
n Total net income is 26 + (4 x 13) = $78
§ A net gain of $13 compared to the first scenario

53
©2015 McGraw-Hill Education, All Rights Reserved
 A Better Choice

Selling Income per Total Cattle Marginal

# Steers
Price steer Income Income
1 126 26 26 26
2 119 19 38 12
3 116 16 48 10
4 113 13 52 4
5 111 11 55 3

§ Tragedy of the commons is the tendency for a resource that has

no price to be used until its marginal benefit is zero
§ The essential cause of the tragedy of the commons is the fact
that one person’s use of commonly held property imposes an
external cost on others by making the property less valuable
54
©2015 McGraw-Hill Education, All Rights Reserved
 The Effect of Private Ownership

n The villagers decide to auction off the

rights to the commons
Ø Auction makes the highest bidder consider the
opportunity cost of grazing additional steers
Ø Villagers can borrow and lend at 13%
Ø One steer is the optimal number à income of
$26
n Winning bidder pays $100 for the right to
use the commons
§ Since its use generates an income of $26 per year,
or $13 more than the opportunity cost of your
investment in the steer, the most you would pay is
$100
55
©2015 McGraw-Hill Education, All Rights Reserved
 The Effect of Private Ownership

n The winning bidder starts the year

Ø Spends $100 in savings to buy a year-old
steer
Ø Borrows $100 at 13% to get control of
commons
n The winning bidder ends the year
Ø Sells the steer for $126
§ Gets original $100 back
§ $13 opportunity cost of buying a steer
§ $13 interest on loan for the commons
n Economic surplus of the village is
(4 x $13) + $26 = $78 56
©2015 McGraw-Hill Education, All Rights Reserved
 Property Rights and the Tragedy of
Commons

Berries in the Park Shared cold drinks

§Sweetness increases as the § Cold drinks chill taste buds
berry ripens
Ø Decrease appreciation of
§Berries are common property its flavor
§ Berries will be eaten
Ø Drinking slowly increases
before they are fully ripe
appreciation
Other Examples
§Harvesting § If two people share the cold
drink, it is a common good
§ Timber on remote public
land Ø They will drink faster than
§ Whales in open oceans if it were a private good
§Worldwide pollution
57
©2015 McGraw-Hill Education, All Rights Reserved
 Positional Externalities

n Highest compensation goes to the best

performer
Ø Standard is also relative, not only absolute

n Each player increases spending to

increase probability of winning
Ø Sum of all these investments > collective
payoff
§ Total payout is fixed, so players' group has no
gains
58
©2015 McGraw-Hill Education, All Rights Reserved
 Professional Athletes Take Steroids

n Muntasir and Nasir compete for the gold medal

Ø Each has 50% chance at the gold medal
n Muntasir and Nasir have a Prisoner's Dilemma

Nasir's Options
Muntasir's
No Steroids Steroids
Options
Worst for Muntasir
No Steroids 2nd best for each
Best for Nasir
Best for Muntasir
Steroids 3rd best for each
Worst for Nasir

59
©2015 McGraw-Hill Education, All Rights Reserved
 Positional Externalities

n Relative performance determines reward

Ø Positional externalities occur when an
increase in one person's performance reduces
the expected reward of another
n A positional arms race is a series of
mutually offsetting investments in
performance enhancement that is
stimulated by a positional externalities
Ø Apositional arms control agreement
attempts to limit the mutually offsetting
investments in performance enhancements by
contestants
60
©2015 McGraw-Hill Education, All Rights Reserved
 Examples of Positional Arms Control
Agreements

n Campaign spending limits

n Roster limits
n Arbitration agreements
n Mandatory starting dates for
kindergarten
n Nerd norms
n Fashion norms
n Norms of taste
n Norms against vanity
61
©2015 McGraw-Hill Education, All Rights Reserved