Chapter 5 Externalities: Problems and Solutions
Externality Externalities arise whenever the
actions of one party make another party worse
Basic Model or better off, yet the first party neither bears the
costs nor receives the benefits of doing so.
Price Regulation (Taxes) Versus Quantity Regulation in This
Model
Negative production externality When a firm’s production
Policy option 1: Quantity Regulation reduces the well-being of others who are not compensated by
Distinctions Between Price and Quantity the firm.
Policy option 2: Price Regulation Through a Corrective Tax Multiple Plants with Different Reduction Costs
Approaches to Addressing Externalities Private marginal cost (PMC) The direct cost to producers of
Policy option 3: Quantity Regulation with Tradable Permits
producing an additional unit of a good.
Implications for Effect of Price and Quantity interventions
Social marginal cost (SMC) The private marginal cost to
Uncertainty About Costs of Reduction
Implications for instrument Choice producers plus any costs associated with the production of the
Economics of Negative Production Externalities good that are imposed on others. One confusing aspect of the graphical analysis of externalities is
knowing which curve to shift and in which direction. To review,
Private marginal benefit (PMB) The direct benefit to consumers there are four possibilities:
Corrective Taxation
of consuming an additional unit of a good by the consumer. Negative production externality: SMC curve lies above PMC
Subsidies curve.
Social marginal benefit (SMB) The private marginal benefit to Positive production externality: SMC curve lies below PMC
Public-Sector Remedies for Externalities consumers minus any costs associated with the consumption of curve.
Regulation the good that are imposed on others. Negative consumption externality: SMB curve lies below PMB
curve.
Negative consumption externality When an individual’s Positive consumption externality: SMB curve lies above PMB
Externality Theory consumption reduces the well-being of others who are not curve.
Internalizing the externality When either private negotiations or
Negative Consumption Externalities compensated by the individual.
government actions lead the price to the party to reflect fully
the external costs or benefits of that party’s actions. Positive production externality When a firm’s production
increases the wellbeing of others but the firm is not
Coase Theorem (Part I) When there are well-defined property
compensated by those others.
rights and costless bargaining, then negotiations between the
party creating the externality and the party affected by the Positive Externalities Positive consumption externality When an individual’s
The Solution
externality can bring about the socially optimal market quantity. consumption increases the well-being of others, but the
individual is not compensated by those others.
Coase Theorem (Part II) The efficient solution to an externality
does not depend on which party is assigned the property rights,
so long as someone is assigned those rights. Market failure A problem that causes the
Private-Sector Solutions to Negative market economy to deliver an outcome that
The Assignment Problem Externalities does not maximize efficiency.
Holdout problem Shared ownership of property rights gives
each owner power over all the others. The Holdout Problem
Free rider problem When an investment has a personal cost The Problems with Coasian Solutions
but a common benefit, individuals will underinvest. The Free Rider Problem
Transaction Costs and Negotiating Problems
Bottom line