Module 13: Externalities, Public Goods, Common Resources

Externalities and Economic Efficiency

Externality- A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service

Externalities can be

  • Positive: extra benefit

  • Negative: extra cost

Externality can cause a difference between

  • private cost: the cost paid by the producer of a good or service

  • social cost: the cost of producing the good or service, including both the private cost and the external cost

Optimal level of production is where

  • MSC = MSB

An externality can also cause a difference between

  • private benefit: the received by the consumer of a good or service

  • social benefit: the total benefit from consuming the good or service, including both the private benefit and the external benefit

Externalities lead to a market equilibrium at a quantity that is not efficient

  • Negative externalities result in overproduction

  • Positive externalities result in underproduction

  • Both lead to a deadweight loss

Market failure- A situation where the market fails to produce the efficient level of output

Solutions and Government Policies

Externalities are the result of

  • incomplete property rights

  • difficulty enforcing property rights

Coase theorem: the idea that private parties can solve the problem of externalities. It requires

  • identifiable and enforceable property rights

  • low transaction costs

It is possible for a tax to cancel out the effects of an externality

  • it would need to be the exact right size, and equal to the size of the cost of the externality

a subsidy would increase the quantity


Pigouvian Taxes and Subsidies- taxes and subsidies that are used to correct externalities

  • increase efficiency

  • bring in tax revenue

Market-Based

  • taxes

  • subsidies

Command-and-Control

  • government imposed quantity limits on production

  • ex: tradable emissions allowances

Four Categories of Goods

Rival: one person's consumption means someone else cannot consume the good

Excludable: a person who does not pay cannot consume the good

Public goods are nonrival and nonexcludable

Free riders- people can benefit from a good without paying for it