• Externality: the uncompensated impact of one person's actions on the well-being of a bystander.

• A positive externality is beneficial, while a negative externality poses adverse effects.

• The market equilibrium is not efficient when there are externalities.

• Society's interest in market outcome involves buyers, sellers, and bystanders when externalities are involved.

• A negative externality can be considered the exhaust from automobiles.

10-1 Externalities and Market Inefficiency

Welfare Economics: A Recap

• Supply and demand curves help gain information on costs and benefits.

• The supply curve reflects the cost of producing steel.

Negative Externalities

• The social cost equals the private costs of the steel producers plus the costs to those bystanders harmed by the pollution.

• Internalizing the externality: altering incentives so that people take into account the external effects of their actions.

• Social cost curves and supply curves differ in the fact that they emit different amounts of pollution.

Positive Externalities

• Social value is more advantageous than private and it's above the demand curve.

• Private school is more beneficial but public schools have positive externalities.

• Industrial policies are often government interventions that hope to promote technology-enhancing industries.

10-2 Public Policies toward Externalities

Command-and-Control Policies: Regulation

• The Environmental Protection Agency is responsible for developing and enforcing regulations aimed at protecting the environment in the United States.

• The government has the power to require or forbid certain behaviors.

• The EPA can determine how many levels of pollution a factory can emit.

Corrective taxes

• A tax designed to induce private decision-makers to take into account the social costs that arise from a negative externality.

• Corrective taxes are often called Pigovian taxes after Arthur Pigou, an economist who used these forms of taxes. They give an economic incentive.

• Economists favor tax over-regulation.

Market-Based Policy 2: Tradable Pollution Permits

• Social welfare becomes enhanced by allowing permits to be sold.

• Polluting firms pay the government and it costs the government more by internalizing the externality.

• Bipartisan action is not on the White House or Congress' agenda.

• Pollution permits are cost-effective ways of keeping the environment clean.

Objections to the Economic Analysis of Pollution

• Some may argue that the environment should be protected at all costs but clean air and water quality has a high opportunity cost of technology and a high standard of living.

• The Law of Demand lowers the price of environmental protection and increases the demand for a clean environment.

10-3 Private Solutions to Externalities

The Types of Private Solutions

• Moral injunctions tell us to think about how our actions will affect others (internalize externalities).

• Charities like non-for-profit organizations get funds through private donations.

• The government encourages private solutions by deducting income taxes from charitable donations.

The Coase Theorem

• Coase theorem: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

Why Private Solutions Do Not Always Work

• Bargaining doesn't always work when trying to use private solutions because the parties have trouble agreeing and reaching one another.

• Transaction costs: the costs that parties incur during the process of agreeing to and following through on a bargain.

  • Ex. The transaction costs for a translator, lawyer, or attorney.

10-4 Conclusion

• Outcomes are efficient when buyers and sellers in markets are the only interested parties.

• When external effects are present, third parties must be taken into account when evaluating a market outcome.