Externalities

What is an externality?

This is when a third-party individual who is not directly involved in the economic decision incurs a benefit or cost as a direct result of the decision. They had no choice in the economic decision.

What is a negative externality?

This is a negative byproduct of a market that impacts people existing outside the market (i.e. pollution)

What is a positive externality?

This is the positive byproduct of a market that impacts people existing outside of the market.

What can we assume about the market if externalities exist?

When externalities do exist, the competitive equilibrium is no longer pareto optimal, suggesting that there is two separate maximization points that must met at one point in order for the market to be in equilibrium while being pareto optimal.

In the case of a negative externality, what is generally true about the equilibrium quantity as opposed the social optimum quantity?

The equilibrium quantity is usually larger than the social optimum quantity - because the market isn’t taking into account the social impacts of the negative externality that would cause the market to produce less.

In the case of a positive externality, what is generally true about the equilibrium quantity as opposed to the social optimum quantity ?

The equilibrium quantity is usually smaller than the social optimum quantity- because the market isn’t taking into account the social impacts of the positive externality that would cause the market to produce more.

What is one way we can push the market in a way that the equilibrium meets the social optimum?

A Pigouvian tax/subsidy

What is the Coase Theorem?

This is the theorem that if externalities exist then negotiations could be made to push the market equilibrium to the social optimum.

What are some assumptions we could make about the Coase Theorem?

1. Well defined Property Rights

2. Low transaction costs

   *The solution is efficient regardless of who is liable

In the case of externalities, what can supply be re-labeled as to better define costs? What can demand be labeled as to better define benefits?

Marginal Private Cost curve and Marginal Private Benefit curve.

What point represents the market equilibrium?

Where marginal private cost = marginal private benefit.

What point represents the social optimum?

Where marginal social cost = marginal social benefit.