Chapter 10: Externalities

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17 Terms

1

Externality

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

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2

If the effect on the bystander is adverse,

it is a negative externality.

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3

If the effect on the bystander is adverse,

it is a positive externality.

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4

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

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5

Internalizing an externality

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

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6

Positive externality

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

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7

If the externality is positive,

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

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8

How are positive externalities internalized?

Government subsidies

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9

types of private solutions to externalities

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

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10

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.

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11

Transaction costs

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

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12

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.

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13

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.

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14

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.

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15

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.

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16

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.

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17

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.

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