1 Chapter 3 Externalities and Government Policy
Overview Chapter 3 introduces you to the important concept of externalities. Externalities are defined simply as costs or benefits of market transactions not reflected in the final prices of goods and services. The chapter seeks to provide you with an understanding of why markets fail to achieve efficiency when externalities exist. A few extended examples are developed to show you how prices fail to reflect marginal social benefit or marginal social cost when positive or negative externalities exist in competitive markets. Another objective of the chapter is to discuss alternative means of internalizing externalities to achieve efficiency. Externalities are internalized when marginal private cost (or marginal private benefit) is adjusted so that resource users consider the actual marginal social cost (or marginal social benefit) of their actions when making decisions. The text considers corrective taxes and subsidies, property rights assignment (the Coase theorem), and emissions stan-dards as alternative means of internalizing externali-ties. 2
• Chapter Outline • Negative and positive externalities • Externalities and Efficiency • How externalities can be internalized • Corrective Taxes • Corrective Subsidies • The Coase Theorem - Property rights assignment • Regulatory Solutions • Global environmental concerns. 3
4 Externalities Externalities are costs or benefits of market transactions not reflected in prices. Externalities can be negative or positive. Negative externalities are costs to third parties. Positive externalities are benefits to third parties .
5 Externalities and Efficiency The marginal external cost (MEC) is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good producing negative externality. In presence of negative externality, the marginal social cost (MSC) is greater than the marginal private cost (MPC) by the amount of MEC. Thus, MSC = MPC + MEC when negative externality exists.
6 Unregulated Output If production creates an externality and is unregulated, greater than the socially efficient output will produced and greater negative externality will be created.
- Fall '11
- Externalities, Externality, negative externality