Understanding Externalities and Market Failures

External Cost

Uncompensated cost that an individual or firm imposes on others.

External Benefit

Benefits that individuals or firms confer on others without compensation.

Externalities

External Benefits and External Costs.

Positive Externalities

Market produces a smaller quantity than is socially desirable.

Negative Externalities

Market produces a larger quantity than is socially desirable.

Market Failure

Free-market equilibrium that is not providing the socially optimal amount of a good.

Marginal Social Cost

Additional cost of society when producing an additional unit.

Private Cost

Cost directly incurred by sellers.

Private Value

Value to buyers.

Internalizing Externality

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

Social Value

Private Value and External Benefit.

Coase Theorem

If private parties can bargain without cost over the allocation of resources, they can solve it on their own.

Transaction Costs

Costs that parties incur in the process of agreeing to and following through on a bargain.

Command-and-Control Policies

Regulate behavior directly.

Market-based Policies

Provide incentives so that private decision-makers will choose to solve the problem on their own.

Corrective (Pigouvian) Tax

Induce private decision-makers to take account of the social costs that arise from a negative externality.

Network Externalities

Value of the good to an individual is greater when a large number of other people also use the good.