Lecture 4

🌐 External Costs and Resource Governance

An external cost arises when a resource user’s decision affects others, but the user does not bear the full consequence.

Property rights define which decisions each user may make and which consequences that user must bear.

A resource institution must answer:

Who may use the resource?
Who may exclude others?
Who receives the benefits and bears the costs?
Who may transfer a right?
Who can monitor and enforce the rule?

🔑 Effective Property Rights

Characteristic	Meaning
Exclusivity	The owner or user receives the benefits and bears the costs
Transferability	Rights can move voluntarily from one owner to another
Enforceability	Rights are protected against seizure or encroachment

In economics, property rights are a bundle of entitlements governing resource use.

Rights may belong to individuals, a defined group, or the state. Efficiency weakens when important costs remain outside the right holder’s decision.

🧩 Rivalry and Excludability

	Excludable	Difficult to exclude
Rival	Private good (timber)	Common-pool resource (fishery, aquifer)
Nonrival	Club good (gated park)	Public good (biodiversity, climate stability)

Rivalry: one person’s use reduces the amount or quality available to others.

Excludability: access can be limited to authorized users at reasonable cost.

🏛️ Four Governance Regimes

Regime	Who controls access?
Private property	An individual or firm
State property	A public authority
Common property	A defined user community
Open access	No actor exercises effective exclusion

Common property has rules and a defined group of users. Open access lacks effective exclusion.

🤝 Common Property: Success and Failure

Case	Institutional result
Swiss Alpine grazing	A stable user group and enforceable livestock limits discouraged overgrazing
Mawelle fishing village, Sri Lanka	A rotating access system weakened as outsiders entered and population pressure increased

The strength of common property depends on boundaries, rules, monitoring, and compliance.

🦬 American Bison as a Common-Pool Example

Northern and Southern Bison Herds in 1865

Early U.S. period:
- Abundant bison; unrestricted hunting did not impose noticeable scarcity costs.
As demand/technology rose:
- Scarcity emerged; each hunter’s effort reduced others’ catch per unit effort.
Open access + scarcity ⇒ escalating effort, falling stocks, near-extinction.

📈 Total Framework

Total benefit and total cost as functions of harvest effort. The efficient effort maximizes the vertical resource-rent gap.

Total Surplus (Profit) $TS(E) = TB(E) - TC(E)$.
Total Benefit (Total Revenue) $TB(E)$: increase with effort at a diminishing rate.
Total Cost $TC(E)$: increases with effort $E$ (linear if marginal cost $c$ is constant).
Efficient effort $E^{*}$: maximizes the vertical gap between $TB$ and $TC$.

📉 Marginal Framework

Marginal and average benefits with constant marginal and average cost. Efficient and open-access effort are marked.

Marginal Benefit $MB(E) = \frac{dTB}{dE}$ declines as stock falls with effort.
Marginal Cost $MC(E)$ (e.g., constant $c$).
Efficiency: $MB(E^{*}) = MC(E^{*})$.
Two panels are equivalent representations of the same optimum.

🎯 Efficient Effort $E^{*}$

Two vertically stacked ggplot panels share an aligned harvest-effort axis. The top panel shows the efficient effort at the maximum gap between total benefit and total cost. The bottom panel shows marginal benefit equal to marginal cost at the same effort.

Top panel: $E^{*}$ maximizes the resource rent, $TB-TC$.
Bottom panel: the same effort satisfies $MB=MC$.
At $E^{*}$, the last unit of effort adds as much benefit as it costs.

🚪 Open-Access Effort $E_{OA}$

Two vertically stacked ggplot panels share an aligned harvest-effort axis. The top panel shows total benefit equal to total cost at open-access effort. The bottom panel shows average benefit equal to average cost at the same effort.

Top panel: $TB=TC$, so total surplus is zero.
Bottom panel: free entry stops where $AB=AC$ because each user earns zero profit.

Because $AB=TB/E$ and $AC=TC/E$, the conditions are equivalent:

\[ AB=AC \;\Longleftrightarrow\; TB=TC \;\Longleftrightarrow\; TS=0. \]

⚠️ Open-Access Overuse

No exclusion ⇒ no one can secure surplus.
Each user ignores the stock-scarcity cost: the stock externality that current effort imposes on other users now and on future resource users.
With free entry, effort keeps expanding until per-user profit $=0$.
- This drives total economic rent to zero.
Why does effort go too far?
- When total benefits ($TB$) flatten under diminishing returns, the average benefit ($AB$) stays above the marginal benefit ($MB$).
- Users enter while $AB>AC$, even after $MB<MC$, so effort rises past the efficient level.
Result: $\;\;E_{OA} > E^{*}$ and all rents are dissipated.

🎁 Public Goods and Underprovision

In competitive markets, demand = willingness to pay (WTP) for private goods.
For public goods, individual WTP understates marginal benefit (MB) because people can consume even if they pay less (or nothing).
Result: Free riding → $\text{(Total Voluntary Funding)} \,<\,\text{(Cost)}$ → Underprovision.

Note

Market failure here is on the demand side, unlike common-pool overuse, which arises from decisions on the production side.

➕ Vertical Summation of Public-Good Benefits

1. Doug's marginal benefit

2. Add Sasha’s marginal benefit

At $Q=10$, their values are $5 and $2.

3. Sum the benefits vertically

$SMB(Q)=MB_D(Q)+MB_S(Q)$.

At $Q=10$, $SMB=\$5+\$2=\$7=SMC$. Therefore, $Q^{*}=10$.

💵 Funding the Efficient Quantity

At $Q^{*}=10$, total cost is $70. Efficiency determines how much to provide. Financing determines who pays.

Financing rule	Example	Main consideration
Uniform tax	Doug pays $35 and Sasha pays $35	Simple, but ignores benefit differences
Benefit-based shares	Doug pays more because his marginal benefit is higher	Better aligned with benefits, but true willingness to pay is hard to observe
Ability-to-pay	Contributions rise with income	Addresses equity, but does not track individual benefits

🧭 Institutional Paths Toward Efficiency

Ill-defined rights can separate private choices from collective costs and benefits. Two institutional pathways can address this gap:

Pathway	Main mechanism	Best suited to
Judicial liability	Compensation for demonstrated harm after the fact	Distinct events with identifiable sources and victims
Legislative and executive regulation	Rules, limits, standards, and information requirements before harm occurs	Repeated or diffuse harms involving many parties

Both pathways can fail when information or enforcement is weak.

⚖️ Judicial Liability: Mechanism

How it works

After harm occurs, liability law requires the responsible party to pay compensation that corresponds to the damage.
Strict liability can apply even without negligence or fault, especially for abnormally dangerous activities.
Negligence asks whether the party exercised the legally required level of care.

Oil-spill example

A company expects to pay for cleanup and compensate injured parties if a spill occurs.
When prevention costs less than expected cleanup and damages, prevention becomes privately valuable.
Liability internalizes the external cost, moving the company’s choice closer to the efficient outcome.

⚠️ Limits of Judicial Liability

Courts must identify the responsible party and estimate the damages.
Transaction costs are the costs of reaching and enforcing a fair outcome. Examples include court time, legal fees, and expert testimony.
These costs rise with many parties or recurring disputes.
One general rule can reduce these costs in recurring cases.

Contrast: Courts can more easily assign liability for a single oil spill with a clear source than for ongoing pollution from many sources.

Coase Theorem

When property rights are clearly defined and transaction costs are low, affected parties can bargain toward an efficient outcome. The initial assignment of rights still determines who pays and who receives compensation.

🚧 Regulation: Activity and Access

Rule	What it controls	Natural-resource example
Activity limit	The quantity of emissions, withdrawals, or harvest	Catch quota or groundwater-pumping limit
Spatial or timing rule	Where and when use may occur	Seasonal closure, no-take zone, or wetland setback
Access or entry rule	Who may use the resource	Limited permits or grazing leases

Effective rules need measurable limits, credible monitoring, and enforceable penalties.

🧾 Regulation: Practice and Information

Rule	Purpose	Natural-resource example
Input or process standard	Requires protective practices or prohibits damaging methods	Fishing-gear restriction or forestry best-management practice
Safety or licensing rule	Sets operator qualifications and operating conditions	Resource-use permit or spill-response plan
Disclosure, certification, or labeling	Makes environmental performance visible	Pollution-release reporting or sustainable-resource certification

Verification and enforcement matter. Weak information or rent seeking can create government failure.

🏞️ Property Rights, Open Access, and Resource Institutions

🌐 External Costs and Resource Governance

🔑 Effective Property Rights

🧩 Rivalry and Excludability

🏛️ Four Governance Regimes

🤝 Common Property: Success and Failure

🦬 American Bison as a Common-Pool Example

📈 Total Framework

📉 Marginal Framework

🎯 Efficient Effort \(E^{*}\)

🚪 Open-Access Effort \(E_{OA}\)

⚠️ Open-Access Overuse

🎁 Public Goods and Underprovision

➕ Vertical Summation of Public-Good Benefits

💵 Funding the Efficient Quantity

🧭 Institutional Paths Toward Efficiency

⚖️ Judicial Liability: Mechanism

How it works

Oil-spill example

⚠️ Limits of Judicial Liability

🚧 Regulation: Activity and Access

🧾 Regulation: Practice and Information