Chapter 5 EXTERNALITIES When actions spillover to affect 3rd parties

5 Chapter Outline and Learning Objectives CHAPTER 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. 5.4 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.

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

A sign of market failure 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? 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 Private good. A good that is both rival and excludable. Public good. A good that is both nonrivalrous and nonexcludable. Free riding Benefiting from a good without paying for it. Quasi-public goods. Goods that are excludable but not rival. Common resource. A good that is rival but not excludable.

How does corrective tax help reduce negative externality 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