Chapter 15 econ

Externality

A cost or benefit that affects someone not directly involved in the market

Negative externality

harms others (MSC > MC) market produce to much (Overproduction)

Positive externality

benefits others (MSB > MB) Market produce to little (underproduction)

Negative production externality

firm harms others (pollution)

Positive production externality

firm benefits others (bees pollinate)

Negative consumption externality

consumer harms others (smoking)

Positive consumption externality

consumer benefits others (vaccines)

Marginal private cost (MC)

cost to the producer

Marginal external cost

cost to others

Marginal social cost (MSC)

total cost to society (MSC = MC + external cost)

Marginal private benefit (MB)

benefit to the consumer

Marginal external benefit

benefit to others

Marginal social benefit (MSB)

total benefit to society (MSB = MB + external benefit)

Efficient Rule

MSB = MSC

Market Failure

Free market ignores external costs and benefits

Property Rights

Ownership forces firms to consider external costs

Coase Theorem

Coase Theorem (super simple):

• If people clearly own something (property rights)

• And it’s easy to make deals (low transaction costs)

Then people will negotiate and fix the problem themselves
And end up at the best (efficient) outcome

Pigovian Tax

Tax equal to marginal external cost

Effect:

reduces output

reduces pollution

moves to efficient outcome

Cap-and-Trade

A cap is a legal maximum amount of pollution allowed.

Government:

sets total allowed pollution

gives or sells permits

lets firms trade the permits

Public Production

government provides the good

Subsidy

Payment to increase production

Vouchers

Government gives money to consumers to buy goods

Patents / Copyrights

Give exclusive rights to encourage innovation

Global Externalities

Global warming is a global externality.

A cleaner atmosphere is a global public good.

Why it is hard to solve:

free-rider problem

carbon leakage

countries want others to reduce emissions while they avoid the cost

why Negative Externalities produce Overproduction

5. Why negative externalities cause overproduction

In an unregulated market, firms produce where:

MC = MSB (or MB)

But the true efficient rule should be:

MSC = MSB

Since MSC is above MC, the market output is too high.

Why?

Because firms ignore the outside harm.

So the market produces too much and creates deadweight loss.

How to cope with negative externalities

Three main methods:

A) Property rights

If ownership rights are clearly defined, the producer must take the external cost into account.

This can lead to:

using cleaner technology

producing less

reducing pollution

B) Mandate clean technology

Government directly requires cleaner production methods.

C) Tax or cap-and-trade

Government makes polluters pay for the harm.

Why positive externalities cause underproduction

A private market produces where:

MB = MSC (Or MC)

But the efficient rule is:

MSB = MSC

Since MSB is above MB, the market quantity is too low.

Why?

Because buyers ignore the outside benefits.

So the market produces too little and creates deadweight loss.

How to cope with positive externalities

A) Public production

Government directly provides the good or service.

Example:

public schools

B) Private subsidies

Government pays firms to produce more.

C) Vouchers

Government gives households tokens to buy certain services.

Example:

education vouchers

D) Patents and copyrights

Government grants exclusive rights so creators can capture more of the benefit.