Externality Theory: Problems and Solutions

These flashcards cover key terms and concepts related to externality theory, market failures, and potential solutions.

Externality

A situation where the actions of one economic agent affect another agent's welfare but the first agent does not bear the costs or gain the benefits.

Market Failure

A problem that occurs when the assumptions of the welfare theorem are violated, leading to inefficiencies in a market economy.

Private Marginal Cost (PMC)

The direct cost incurred by producers when producing one additional unit of a good.

Marginal Damage (MD)

The additional costs imposed on others as a result of the production of a good that producers do not pay.

Social Marginal Cost (SMC)

The total cost to society of producing an additional unit of a good, calculated as PMC plus MD.

Negative Production Externality

Occurs when a firm's production reduces the welfare of others who are not compensated for this reduction.

Positive Production Externality

Occurs when a firm's production increases the welfare of others, but the firm is not compensated for this increase.

Social Costs and Benefits

The costs and benefits associated with an economic activity that affect all of society, including those not directly involved.

Coase Theorem

A principle that suggests that if property rights are well-defined and bargaining costs are low, parties can negotiate to a socially optimal level of production regardless of who holds the rights.

Pigovian Tax

A tax imposed on activities that generate negative externalities, aimed at aligning private costs with social costs.