Chapter 5
EXTERNALITIES
When actions spillover to affect
3rd parties
CHAPTER
5
Chapter Outline and Learning Objectives
5.1
Externalities and Economic Efficiency
Identify examples of positive and negative externalities and use graphs to show how
externalities affect economic efficiency.
5.2
Private Solutions to Externalities: The Coase Theorem
Discuss the Coase theorem and explain how private bargaining can lead to economic
efficiency in a market with an externality.
5.3
Government Policies to Deal with Externalities
Analyze government policies to achieve economic efficiency in a market with an
externality.
Four Categories of Goods
Explain how goods can be categorized on the basis of whether they are rival or
excludable, and use graphs to illustrate the efficient quantities of public goods and
common resources.
5.4
Externality
• A benefit or cost that affects someone who
is not directly involved in the production or
consumption of a good or service.
EXTERNALITIES
• A sign of market failure
So far, we have only looked at situations where our
decisions have had no influence on others
What happens if our actions do affect others, yet we
don’t take this into account?
Externalities
• EXTERNALITIES - Results of
consumption/production decisions that
affect 3rd parties (ie. Not those
consuming/producing)
Externalities - could be positive (external benefit)
or negative (external cost)
Why do externalities matter?
• Inefficient allocation of resources occur
when externalities are present.
Examples:
1) Negative externality (pollution, noise)
2) Positive externality (education, health care)
Solving the Externalities Problem:
Private Solutions
Coase Theorem:
If transactions costs are low, private
bargaining will result in an efficient
solution to the problem of externalities.
Solving the Externalities Problem
• What can we do to solve this problem?
1) Property Rights - social arrangements that govern the use,
ownership, and disposal of factors of production, goods and services
- these are legally enforceable
2) Also, we could INTERNALIZE THE EXTERNALITY
This is done by adjusting the marginal cost/benefit of a
good/service so efficient allocation is achieved.
2 ways to do this:
1) Corrective Tax (Pigovian Tax)
2) Corrective Subsidy (Pigovian Subsidy)
Four Categories of Goods
Four Categories of Goods
1. Private good. A good that is both rival and excludable.
2. Public good. A good that is both nonrivalrous and
nonexcludable.
Free riding Benefiting from a good without paying
for it.
3. Quasi-public goods. Goods that are excludable but not
rival.
4. Common resource. A good that is rival but not
excludable.
How does corrective tax help reduce negative externality?
Will do example in class.
How does subsidy help increase positive externality?
Will do example in class.
Know these Definitions
Coase theorem
Command-and-control approach
Common resource
Excludability
Externality
Free riding
Market failure
Pigovian taxes and subsidies
Private benefit
Private cost
Private good
Property rights
Public good
Rivalry
Social benefit
Social cost
Tragedy of the commons
Transactions costs