Market Externalities

What is a market externality?

A market externality is a cost or benefit caused by a transaction that impacts a third party who did not choose to be involved.

Positive externality

A positive externality occurs when a third party benefits from a transaction without having to pay for it.

Negative externality

A negative externality occurs when a third party suffers from a transaction without being compensated.

Examples of negative externalities

Pollution, secondhand smoke, and congestion are common examples of negative externalities.

Examples of positive externalities

Education, vaccination, and public parks are examples of positive externalities.

Marginal social cost (MSC)

MSC is the total cost to society for the production of an additional unit of a good, including private costs and external costs.

Marginal private cost (MPC)

MPC is the cost incurred by producers for the production of one more unit of a good, not including external costs.

Socially optimal level of output

The socially optimal level of output occurs where marginal social cost equals marginal social benefit.

Internalizing an externality

Internalizing an externality involves altering incentives so that people take account of the external effects in their actions.

Government intervention

Government intervention may be used to correct market failures caused by externalities, through taxes, subsidies, or regulation.

Pigovian tax

A Pigovian tax is a tax imposed on activities that create negative externalities to encourage reduction in that activity.

Subsidies for positive externalities

Subsidies can be financial incentives given by the government to promote activities that generate positive externalities.

Coase theorem

The Coase theorem states that if property rights are well-defined and transaction costs are low, parties can negotiate to resolve externalities.

Public goods

Public goods are goods that are non-excludable and non-rivalrous, often leading to underproduction in a free market.

Tragedy of the commons

The tragedy of the commons occurs when individuals exploit a shared resource to the extent that it becomes unavailable to others.

Excludability

Excludability refers to the ability to prevent someone from using a good or service.

Rivalry in consumption

Rivalry in consumption means that one person's use of a good reduces the availability for another person.

Market failure

Market failure occurs when the allocation of resources by a free market is not efficient, often due to externalities.

Negative externalities and social welfare

Negative externalities can lead to a decrease in overall social welfare as they impose costs on third parties.

Positive externalities and market inefficiency

Positive externalities can result in market inefficiency as the benefits to society are not reflected in the price of the good.

Correcting market failures

To correct market failures from externalities, policymakers may employ regulatory approaches, market-based solutions, or a combination of both.