Externalities come in many varieties as do the policy responses that try to

Externalities come in many varieties as do the policy

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Externalities come in many varieties, as do the policy responses that try to deal with the market failure. Here are some examples: The exhaust from automobiles is a negative externality because it creates smog that other people have to breathe. As a result of this externality, drivers tend to pollute too much. The federal government attempts to solve this problem by setting emission standards for cars. It also taxes gasoline to reduce the amount that people drive. Restored historic buildings convey a positive externality because people who walk or ride by them can enjoy the beauty and the sense of history that these buildings provide. Building owners do not get the full benefit of restoration and, therefore, tend to discard older buildings too quickly. Many local governments respond to this problem by regulating the destruction of historic buildings and by providing tax breaks to owners who restore them. Barking dogs create a negative externality because neighbors are disturbed by the noise. Dog owners do not bear the full cost of the noise and, therefore, tend to take too few precautions to prevent their dogs from barking. Local governments address this problem by making it illegal to "disturb the peace." Research into new technologies provides a positive externality because it creates knowledge that other people can use. Because inventors cannot capture the full benefits of their inventions, they tend to devote too few resources to research. The federal government addresses this problem partially through the patent system, which gives inventors exclusive use of their inventions for a limited time. In each of these cases, some decision maker fails to take account of the external effects of his or her behavior. The government responds by trying to influence this behavior to protect the interests of bystanders. 1
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10-1 Externalities and Market Inefficiency In this section, we use the tools of welfare economics developed in Chapter 7 to examine how externalities affect economic well-being. The analysis shows precisely why externalities cause markets to allocate resources inefficiently. Later in the chapter, we examine various ways in which private individuals and public policymakers may remedy this type of market failure. 10-1a Welfare Economics: A Recap We begin by recalling the key lessons of welfare economics from Chapter 7. To make our analysis concrete, we consider a specific market–the market for aluminum. Figure 1 shows the supply and demand curves in the market for aluminum. Figure 1. The Market for Aluminum The demand curve reflects the value to buyers, and the supply curve reflects the costs of sellers. The equilibrium quantity, QMARKET , maximizes the total value to buyers minus the total costs of sellers. In the absence of externalities, therefore, the market equilibrium is efficient.
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