ECON_10

10.1 Identifying Externalities

• 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.

Types of Externalities

• 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.

10.2 The Externality Problem

• 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:

  1. Predict equilibrium quantity (supply equals demand).

  2. Assess externalities involved (positive or negative).

  3. Find socially optimal quantity (where marginal social benefit = marginal social cost).

  4. Compare equilibrium quantity with socially optimal quantity.

10.3 Solving Externality Problems

• 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).

10.4 Public Goods and the Tragedy of the Commons

• 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.

10.5 Tying It Together

Six Key Insights for Dealing with Externalities:

1. Don’t intervene if unnecessary: Let market forces solve the problem if feasible.

2. Complement market forces: Prefer taxes/subsidies over regulations.

3. Adapt solution to uncertainty: Use taxes when marginal external costs are known; quantities when optimal production levels are known.

4. Evaluate costs and benefits of regulations/private goods: Ensure benefits exceed costs.

5. Aim for outcomes, not means: Allow flexibility in achieving goals to find efficient methods.

6. Encourage innovation: Policies should promote the development of new solutions.