Chapter all: Externalities

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1 Dec 2016
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Externalities
An externality is when the decisions of an individual impact the well-being
of an uninvolved bystander.
o Externalities can cause market failures.
o If the impact on the bystander is costly, it is a negative externality.
o If the impact on the bystander is beneficial, it is a positive externality.
Externalities and Market Inefficiency
o If production of a good or service has a negative externality to
society, then it is said to have a social cost which includes both the
private costs to the producer and the costs to the bystanders
affected by the externality.
Government may attempt to account for the social cost
through a tax known as internalizing the externality because
it alters incentives to bring awareness to the external effects of
action.
o If production of a good or service has a positive externality to
society, then it is said to have a social value which is greater than
the private value of the good or service from the producer.
Government may attempt to internalize the externality through
a subsidy, bringing awareness to the positive external effects
of action.
Public Policies toward Externalities
o Government may attempt to account for externalities through
regulation that requires or forbids certain behavior.
o Taxes which attempt to account for negative externalities are called
corrective taxes or Pigovian taxes.
Corrective taxes are typically more efficient than regulations
because they alter incentives to reach a social optimum and
raise revenue for the government.
o Permits are equally as efficient as corrective taxes because they can
keep the intensity of the negative externality equal to the intensity
under a corrective tax.
Private Solutions toward Externalities
o The private sector can internalize externalities by:
Following moral codes and social sanctions.
Establishing a variety of charities.
Relying on the self-interest of other parties.
Constructing contracts for the involved parties to agree on.
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o The Coase theorem states that if private parties have the ability to
bargain without cost the allocation of scarce resources, then they
can solve the problem of externalities as well.
Private parties may be unable to solve externalities because
of the cost of the process to agree and follow a bargain or the
transaction costs.
Review Questions
1. Which of the following is an example of an activity with an external cost?
(A) Raising honeybees where neighbors on all sides grow apples
(B) Speeding on the Interstate
(C) Having to buy batteries for the new remote that came with a TV
(D) Keeping the front yard clean
Ans.: B, a negative externality is implied. It occurs when producing or consuming a
good or service that imposes a cost upon a third party.
2. Which of the following is not an example of an activity with external benefits?
(A) Having your smoking car repaired
(B) Staying home from class when you have the flu
(C) Planting flowers in the front yard
(D) Eating a sandwich in the dining hall
Ans.: D, There is no external benefit for eating a sandwich in a dining hall. In options
A,B,C. A, B,C all have a social benefit that will be greater than private benefit.
3. If an industry ignores the external costs it generates in the production, which of
the following will be true at the competitive market equilibrium output?
(A) Price will be greater than the marginal social cost.
(B) Price will be less than the marginal social cost.
(C) Price will be equal to the marginal social cost.
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