Externalities and Solutions

What is an externality?

A cost or benefit affecting a third party not directly involved in a transaction.

What is a negative externality?

An uncompensated external cost causing the market to produce or consume too much.

What is a positive externality?

An external benefit causing the market to produce or consume too little.

What is the difference between production and consumption externalities?

Production externalities arise from producing goods while consumption externalities arise from using them.

Why does ordinary supply and demand fail with externalities?

Market prices reflect private costs and benefits rather than all social costs and benefits.

How do private and social costs differ?

Marginal social cost equals marginal private cost plus marginal external cost.

How do private and social benefits differ?

Marginal social benefit equals marginal private benefit plus marginal external benefit.

How do you graph a negative production externality?

The social cost curve lies above private supply and the efficient quantity is below the market quantity.

How do you graph a positive consumption externality?

The social benefit curve lies above private demand and the efficient quantity exceeds the market quantity.

What determines the socially efficient quantity?

The quantity where marginal social benefit equals marginal social cost.

Why do externalities create deadweight loss?

The market quantity differs from the efficient quantity resulting in lost potential total social surplus.

How does a Pigouvian tax correct a negative externality?

It makes decision-makers face external costs and reduces quantity toward the efficient level.

How does a subsidy correct a positive externality?

It encourages beneficial activity that the market would otherwise underprovide.

What is a tradable pollution permit?

A transferable right to emit a specified amount of pollution under an overall cap.

Why can tradable permits reduce pollution efficiently?

Firms with cheaper pollution reduction reduce more and sell permits to firms with higher reduction costs.

What are private solutions to externalities?

Negotiation and voluntary agreements and coordinated action between affected parties.

When can private bargaining solve externalities?

When property rights are clear and transaction costs are low enough for agreement.

Why might private solutions fail?

High transaction costs and many affected parties and difficulties negotiating or enforcing agreements.

How do equity and efficiency differ?

Efficiency maximizes total surplus while equity concerns how costs and benefits are distributed.

Can an efficient environmental policy still be inequitable?

Yes because it may maximize total welfare while placing disproportionate burdens on disadvantaged groups.