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Tragedy of the Commons
Economic Efficiency requires among other things that people make decisions on the basis of accurate prices – we must receive full benefits for anything we produce and we must pay full cost of any resources we consume. Positive and Negative Externalities refer to situations where this accurate price condition does not hold. A world without patents could produce numerous positive externalities – e.g. you work ten years to develop a remedy for migraine headaches and as soon as the remedy is perfected, anybody else can copy and sell – no royalties to you required. But economic efficiency would be harmed because many fewer people would go into research.
A famous example of a negative externality is the Tragedy of the Commons. In this simple example, cows are purchased and are sent to graze on the commons until it is time to sell them for slaughter. The price the cow brings depends on her weight at the time of sale; the weight of the cow depends on the amount of grass she has eaten; the amount of grass she has eaten depends on the number of other cows that are grazing on the commons.
When Farmer Kang a farmer adds a cow to the commons, that cow, by eating some of the grass, imposes a cost on all other farmers because their cows now won’t gain as much weight. But this is an external cost, a cost Farmer Kang does not have to pay, and so he does not consider the cost in deciding whether to buy a cow and graze it on the commons.
In the example below, cows cost $1.00 each to purchase and raise and cows sell for $1.00 per pound of weight. See how adding a cow to the commons reduces the weight of all cows. Keep adding cows until the point where the last farmer to add a cow barely makes a profit.
Question: At the point where the last farmer barely makes a profit, what is the total profit generated on the commons? Could this profit be raised if fewer farmers grazed cows? How do you explain why the farmers “overshot” their profit maximizing point?