Chapter 16 Externalities Externalities spillovers are the impacts on third parties of a transaction between other parties Negative externality if it imposes costs on others it is an external cost Positive externality if the third party benefits it is an external benefit Examples of external costs o Air and water pollution o Texting while driving o Chemical runoff that affects fish stocks Examples of external benefits o Education o Beehives next to almond orchards o Preserved farmland Is the market always efficient Market failure free market equilibrium does not provide the social optimal amount of a good Left to itself a market economy will typically generate too much pollution because polluters have no incentive to take into account the cost they impose on others Costs and Benefits of Pollution The marginal social cost of pollution is the additional cost imposed on society as a whole by an additional unit of pollution o Acid rain smog contaminated water etc The marginal social benefit of pollution is the additional gain to society as a whole from an additional unit of pollution o Goods and services jobs etc The socially optimal quantity of pollution is the quantity society would choose if all costs and benefits were fully accounted for o The socially optimal amount of pollution is not zero Why a market economy produces too much pollution In a market economy without government intervention those who benefit from pollution like the owners of power companies decide how much pollution occurs Private Solutions to Externality Problems In certain situations the private sector can resolve externalities Solving problems requires time and effort o Economist Ronald Coase pointed out that in an ideal world the private sector could deal with externalities o Coarse theorem even in the presence of externalities an economy can always reach an efficient solution provided that the transaction costs are sufficiently low o Transaction costs all the costs to individuals of making a deal o Coarse s analysis argues that individuals have an incentive to find a way to make mutually beneficial deals that lead them to internalize the externality take externalities into account when making decisions Ex a family agrees to stop playing loud music during their neighbor child s naptime in exchange for use of the lawnmower Policies for Pollution Environmental standards rules that protect the environment by specifying actions by producers and consumers Emissions tax cost depends on the amount of pollution a firm produces Tradable emissions permits licenses to emit limited quantities of pollutants the licenses can be bought and sold by polluters Environmental standards are inflexible and don t allow reductions in pollution to be achieved at minimum cost emissions tax ensures that the marginal benefit of pollution is equal for all sources of pollution So emissions tax is the best policy for pollution How emissions tax can solve an externality problem o Positive Externalities The marginal social benefit of a good or activity is equal to the marginal benefit that accrues to consumers plus its marginal external benefit Ex education creates benefits for students and the society they live in External benefits a benefit received by people other than the consumers and producers trading in the market How a Subsidy can solve an externality problem Technology spillover an external benefit that results when knowledge spreads among individuals and firms Network externalities a good is subject to a network externality when the value of the good to an individual is greater when a larger number of other people also use the good
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