1 Externalities: A Case of Market Failure

2 Externalities Defined Externality: an uncompensated impact of one’s actions on the well-being of another Can be negative or positive Negative externalities (e.g., pollution) Positive externalities (e.g., defense spillovers) Distinction between private and social perspective is key

3 Production vs. Consumption Externalities A production externality negative: social MC > private MC positive: social MC < private MC A consumption externality negative: social MB < private MB positive: social MB > private MB

4 Externalities and Market Failure With a negative externality, the efficient quantity is less than the equilibrium quantity With a positive externality, the efficient quantity is greater than the equilibrium quantity

5 Potential For Decentralized Solutions Social Norms Social pressure not to generate an externality Voluntary restraint and voluntary price premiums Feel guilty if generate an externality, so use less or pay more to avoid The Coase Theorem Proposition that bargaining between parties can solve the externality problem if property rights are well-established and there are no transactions costs

6 Public Policy Solutions Direct Regulation require that only the efficient quantity is produced Pigovian Tax impose a tax on the good being produced equal to the marginal external cost at the efficient quantity

7 Public Policy Solutions (cont.) A subsidy government pays a subsidy to not produce equal to the marginal external cost at the efficient quantity Tradable Permit System Government issues permits to produce equal to the efficient quantity and allows trading of the permits