chapter 10

Externality

the uncompensated impact of one person’s actions on the well-being of a bystander

we say that there is a negative externality.

If the impact on the bystander is adverse

we say that there is a positive externality

If the impact on the bystander is beneficial

Negative Externality and Its Effect

a steel firm emits pollution during production

Social cost

private cost to the producers + the external cost to bystanders.

Total surplus

the total value of the good to consumers minus the social cost of

producing it. It considers the net economic benefits received by both market

participants and bystanders

Internalizing an externality

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

Positive Externality and Its Effect

Example: vaccinations

Social value

private value to consumers + the external benefit to bystanders.

Public Policies toward Externalities

• The government can respond in two ways:

1) Command-and-control policies: regulate behavior directly

2) Market-based policies: provide incentives so that private decision makers will

choose to solve the problem on their own

Market-Based Policy 1: Corrective Taxes and Subsidies

- Corrective tax

designed to induce private decision makers to take account

of the external cost that arises from a negative externality.

Market-Based Policy 1: Corrective Taxes and Subsidies

- Corrective subsidy

designed to induce private decision makers to

take account of the external benefit that arises from a positive externality.

The Coarse Theorem

If private parties can bargain without cost over the allocation of

resources, they can solve the problem of externalities on their own.

Private solutions do not always work because of

transaction costs and coordination failure