Learning Objective: Identify externalities and their consequences.
Driving impacts not just the driver but others (e.g., air quality, traffic, road wear).
Externalities: Side effects of decisions affecting bystanders, often leading to market failure.
Negative Externality: A side effect that harms others (e.g., pollution from cars).
Examples:
Standing up at concerts blocking views.
Secondhand smoke causing health issues.
Antibiotic overuse developing resistant strains.
Positive Externality: A side effect that benefits others (e.g., vaccination protecting the community).
Examples:
Planting trees improving air quality.
Working hard leading to better community services.
Exercise reducing insurance costs due to better health.
Key Insight: Individuals often ignore broader consequences in decision-making, leading to inefficiencies.
Learning Objective: Analyze how externalities lead to inefficient outcomes.
Markets often yield good outcomes for buyers/sellers but ignore external stakeholders.
Rational Rule for Society: Produce more of an item as long as its marginal social benefit > marginal social cost.
Four-step Analysis for Externalities:
Predict equilibrium quantity (supply equals demand).
Assess externalities involved (positive or negative).
Find socially optimal quantity (where marginal social benefit = marginal social cost).
Compare equilibrium quantity with socially optimal quantity.
Solutions to Externalities:
Private Bargaining: Coase Theorem helps solve externality issues through negotiation.
Corrective Taxes/Subsidies: Use taxes to internalize external costs (e.g., pollution taxes).
Cap and Trade: Limit pollution directly with transferable permits.
Government Regulation: Laws to mitigate negative externalities (e.g., noise restrictions).
Learning Objective: Solve problems arising from nonexcludable goods.
Public Goods: Nonrival and nonexcludable goods (e.g., national security, clean air).
Free-Rider Problem: Individuals consume benefits without paying, leading to underproduction.
Common Resources: Rival but nonexcludable goods (e.g., fish in the ocean), leading to overconsumption.
Don’t intervene if unnecessary: Let market forces solve the problem if feasible.
Complement market forces: Prefer taxes/subsidies over regulations.
Adapt solution to uncertainty: Use taxes when marginal external costs are known; quantities when optimal production levels are known.
Evaluate costs and benefits of regulations/private goods: Ensure benefits exceed costs.
Aim for outcomes, not means: Allow flexibility in achieving goals to find efficient methods.
Encourage innovation: Policies should promote the development of new solutions.