Externalities

Externality

When the production or consumption choices of one person or firm enter the utility or

production function of another without their permission or compensation.

Positive Consumption Externality

When consuming a good, people other than the consumer are

benefited.

Marginal Private Benefit (MPB)

Benefits to an individual from a one-unit increase in production. The

demand function represents these private benefits.

Marginal Spillover Benefit (MSpB)

The benefits that are enjoyed by people other than the person who

directly consumed the good.

Marginal Social Benefits (MSB)

When there are positive consumption externalities, the sum of

Marginal Private Benefits and Marginal Spillover Benefits.

MSB = MPB + MSpB

Market Failure

The competitive market acting on its own fails to produce the efficient amount.

Negative Consumption Externality

When consuming a good, people other than the consumer face

costs.

Marginal Spillover Cost (MSpC)

The costs of an activity that are borne by people other than the person

who directly consumed the good.

Marginal Social Benefits (MSB)

When there are negative consumption externalities, Marginal Private

Benefits minus Marginal Spillover Costs.

MSB = MPB - MSpC

Internalized

When a cost or benefit spillover is worked into the market so that the potential

deadweight loss is minimized.

Negative Production Externality

When producing, people other than the producer bear costs as a

result of the production.

Marginal Private Cost (MPC)

Cost to an individual from a one-unit increase in production. The supply

function represents these private marginal costs.

Marginal Spillover Cost (MSpC)

The increase in total spillover costs that results from a one-unit

increase in production.

Marginal Social Cost (MSC)

The sum of Marginal Private Costs and Marginal Spillover Costs.

MSC = MPC + MSpC

Direct Controls (Command)

Regulations and limits to pollution enforced by government. For example:

emissions limits, technological requirements and environmental assessment reports.

Indirect Controls (Incentive-Based)

Incentive-Based policies create a cost for polluting. They are indirect in that the government is not telling a firm how to cut pollution (or even that it has to cut pollution).

Environmental Taxes

A tax on a negative externality with a dollar amount based on the dollar amount

of damage done per unit. For example: $50 per ton of CO2e emissions.

Cap-and-Trade

A regulation where the government caps the level of pollution at a certain amount and

created tradable rights for the ability to pollute.

Coase Theorem

If the following conditions are met, then any spillover cost or benefit will be

internalized, and the market will be efficient.

Coase Theorem Conditions:

• Property Rights are identifiable

• Property Rights are transferable

• Transaction Costs are low

• Contracts are enforceable