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HUBBARD_MICRO_SG_05 - 5 Externalities Environmental Policy...

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Chapter 5 Externalities, Environmental Policy, and Public Goods Chapter Summary An externality is a benefit or cost that affects someone not directly involved in the production or consumption of a good or service. Negative externalities are costs imposed on individuals not directly involved in producing or consuming a good or service. Positive externalities are benefits received by individuals not directly involved in producing or consuming a good or service. When there is a negative externality as the result of production, the market supply curve understates the full economic cost, the social cost , of production. Economic efficiency would be increased if less of the good or service were produced. When there is a positive externality, the market demand curve understates the full economic benefit, the social benefit , from consumption and too little of the good is produced. Negative and positive externalities lead to market failure . The absence of private property rights or the lack of sufficient enforcement of existing property rights is the underlying cause of externalities and other forms of market failure. Private solutions are possible and efficient if there are low transactions costs. When private solutions to externalities are not feasible, government intervention may be required. For example, if a negative externality is present, government can impose a tax equal to the additional external costs (the difference between the social cost and the private cost). When there are positive externalities, government can provide a subsidy to consumers equal to the external benefits. To reduce pollution, governments have often used a command and control approach . With this approach, the government sets specific quantitative limits on each pollutant emitted, or the government may dictate the installation of specific pollution control devices. One notable exception to the command and control approach was the U.S. government’s attempt to reduce acid rain pollution using a market- based approach. In the Clean Air Act of 1990, Congress required electric utilities to reduce their emissions of sulfur dioxide, a major cause of acid rain. The success of the sulfur dioxide program, which used a system of tradable permits, has led some to suggest that a similar program be used to reduce emissions of so-called “greenhouse gases” that contribute to global warming. Other reasons for government intervention may include cases in which products are rival or excludable. Rivalry occurs when consumption of one unit of a good precludes its consumption by someone else. Excludability means that anyone who does not pay for a good cannot consume it. Because common resources are not privately owned, they are often non-rival, non-excludable, or both. There is a tendency for these common resources to be overused. This result is called the tragedy of the commons . One person’s use of a common resource can impose costs on others, as when one person adding a cow to a common field reduces the grass available to eaten by other people’s cows. Because the private cost of
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