Externalities and Market Inefficiency

These flashcards review key concepts from the lecture on externalities and their impact on market efficiency, government policies, and solutions to externality-related problems.

What is an externality?

An externality is a situation where a person engages in an activity that influences the well-being of bystanders but neither pays nor receives compensation for that effect.

What are the two types of externalities?

Negative externalities, where the impact on a bystander is adverse, and positive externalities, where the impact is beneficial.

How do negative externalities affect market outcomes?

Negative externalities cause the market equilibrium to be inefficient by failing to consider the full social costs of production, leading to overproduction of goods.

What role does the government play in addressing externalities?

The government can implement policies to regulate behaviors or provide incentives, such as corrective taxes and tradable pollution permits, to align private incentives with social efficiency.

What is the Coase theorem?

The Coase theorem posits that if private parties can bargain over the allocation of resources without cost, they can reach an efficient outcome regardless of the initial distribution of rights.

What is a corrective tax?

A corrective tax, or Pigouvian tax, is imposed on activities that generate negative externalities, intended to equal the external cost and thus encourage reduced pollution.

What are tradable pollution permits?

Tradable pollution permits are licenses that allow firms to emit a specific amount of pollution, which can be bought and sold in a market, incentivizing efficient allocation of pollution rights.

What challenges accompany private solutions to externalities?

Challenges include high transaction costs, difficulties in bargaining, and overcoming coordination problems among multiple parties.

Why might education be considered a positive externality?

Education not only benefits the individual through higher wages but also yields societal benefits such as informed voters and reduced crime rates.

What is deadweight loss in the context of externalities?

Deadweight loss occurs when market equilibrium fails to maximize total welfare due to the presence of externalities, leading to an inefficient allocation of resources.