An externality is a side-effect on third parties not directly involved in a market transaction. An externality causes market failure because too much/little of a good is produced so there is a welfare loss. Assume there are two producers near a river, a chemical factory upstream and a fisherman downstream. The chemical factory discharges toxic waste into the river which travels downstream, poisons the water and mutates/kills the fish. So the fisherman suffers because his catch will be less and/or damaged. The chemical factory’s toxic waste imposes an external cost on the fisherman.

    Private costs are the costs incurred by a first or second party directly involved in a market transaction. Private costs include a firm’s input costs or the prices consumers pay for goods. MPC is the marginal private cost of production/consumption. MPC is the market supply curve. External costs are spill-over costs to third parties not directly involved in a market transaction. External costs include air and noise pollution and global warming. Agents do not take responsibility for external costs. Social costs are the sum of private costs and external costs. MSC is the marginal social cost of production/consumption.

    Private benefits are the benefits enjoyed by a first or second party directly involved in a market transaction. Private benefits include a firm’s revenue or the benefit a consumer enjoys from consuming a good. MPB is the marginal private benefit of production/consumption. MPB is the market demand curve. External benefits are spill-over benefits to third parties not directly involved in a market transaction. External benefits include an invention that society benefits from and a better healthcare system making the economy’s workers more efficient. Social benefits are the sum of private benefits and external benefits of a market transaction. MSB is the marginal social benefit of production/consumption.

    The government must intervene to correct market failure. A mechanism must be used to internalize the externality, that is, to make agents take into account the external costs of their actions. Many different mechanisms could be used including taxation, regulation, property rights and marketable permits.

    1) Taxation.

    2) Regulation (Command and Control).

    Regulations and laws directly set the amount produced/consumed in a market to the socially optimum level. A quota system could be set up by the government so that each firm/consumer is only allowed to produce/buy up to a fixed amount.

    3) Property Rights.

    Maybe externalities arise because of undefined property rights. A property right defines who owns a resource and what they can do with it. A chemical factory may discharge toxic waste into a river because nobody owns the river so nobody has the right to stop them. The government could allocate property rights so that agents who are harmed by externalities are given the property rights over the resources being damaged. Agents can then legally stop or charge a price to others who damage their resources. Agents must negotiate how much of the negative externality there will be and what compensation will be paid to the property right owners. The externality is then internalized into the price mechanism and the socially optimum level is reached.

    4) Marketable (Tradable) Permits.

    Marketable permits are created by the government. A pollution level is set at the socially optimum level and divided over a number of permits. Permits are allocated to polluters to let them pollute a certain amount (which sums to the socially optimum level). Polluters can buy or sell permits amongst themselves if they want to pollute more or less.

    Positive Externalities An external benefit is an unpaid for benefit enjoyed by third parties not directly involved in a market transaction.

    The government must intervene to correct market failure. The government could use subsidies or regulation.

    1) Subsidies.

    A subsidy is a grant given by the government to producers to encourage the production of a good. A subsidy can be given to producers equal to the external benefit at the socially optimum level. The subsidy decreases a firm’s private costs and makes MPC shift right. Market price falls from P* to P’ and output rises from Q* to Q’. At , the market is now at its socially optimum level.

    But: – What is the opportunity cost of the subsidy? A decrease in government spending on health, education and/or the infrastructure? Maybe a subsidy for a positive externality should be funded by a Pigouvian tax on a negative externality.

    2) Regulation (State Provision).

    Maybe the government could provide the good/service for free. In the U.S., kindergarten, elementary and high school are all free but a college education must be paid for.

    But: – Providing something for free could cause consumers to use it too much at an inefficiently high level.


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