Chapter 10: Externalities

Externality

The uncompensated impact of one person's actions on the well-being of a bystander.

If the effect on the bystander is adverse,

it is a negative externality.

If the effect on the bystander is adverse,

it is a positive externality.

Negative externality

The harm, cost, or inconvenience suffered by a third party because of actions by others. Ex: Aluminum firms emitting pollution during production-- social cost = private cost of the firm producing aluminum + external costs to bystanders affected by the pollution. Social cost exceeds private cost paid by producers

Internalizing an externality

Altering incentives so that people take account of the external effects of their actions

Positive externality

A benefit received by someone who had nothing to do with the activity that generated the benefit.

If the externality is positive,

social value of the good > private value, and optimum quantity > market quantity

How are positive externalities internalized?

Government subsidies

types of private solutions to externalities

Moral codes and social sanctions, charities, contracts between market participants and the affected bystanders

Coase theorem

The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

Transaction costs

The costs that parties incur in the process of agreeing to and following through on a bargain.

When externalities lead to inefficient allocation of resources in a market, the government can

regulate behavior directly with command-and-control policies, or market-based policies to provide incentives so that private decision makers will chose to solve the problem on their own.

Pigouvian Tax

A tax enacted to correct the effects of a negative externality. Preferred by economists but it persuades firms to reduce things like pollution with the least cost, while firms encountering high costs would simply pay the tax.

Do pigouvian taxes reduce total surplus?

No... they actually INCREASE economic-wellbeing by forcing decision makers to take into account the cost of all the resources being used when making decisions.

Tradable pollution permits

Pollution permits that can be bought and sold in a market. They are an attempt to solve the problem of pollution by creating a market for it.

In case of a tax, the government

sets the price of pollution and firms then choose the level of pollution (given the tax) that maximizes their profit.

If tradable pollution permits are used, the government

chooses the level of pollution (in total, for all firms) and firms then decide what they are willing to pay for these permits.