Externalities: A Case of Market Failure

1
Externalities A Case of Market Failure
2
Externalities Defined

• Externality an uncompensated impact of ones
  actions on the well-being of another
• Can be negative or positive
• Negative externalities (e.g., pollution)
• Positive externalities (e.g., defense spillovers)
• Distinction between private and social
  perspective is key

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Production vs. Consumption Externalities

• A production externality
• negative social MC gt private MC
• positive social MC lt private MC
• A consumption externality
• negative social MB lt private MB
• positive social MB gt private MB

4
Externalities and Market Failure

• With a negative externality,
• the efficient quantity is less than the
  equilibrium quantity
• With a positive externality,
• the efficient quantity is greater than the
  equilibrium quantity

5
Potential For Decentralized Solutions

• Social Norms
• Social pressure not to generate an externality
• Voluntary restraint and voluntary price premiums
• Feel guilty if generate an externality, so use
  less or pay more to avoid
• The Coase Theorem
• Proposition that bargaining between parties can
  solve the externality problem if property rights
  are well-established and there are no
  transactions costs

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Public Policy Solutions

• Direct Regulation
• require that only the efficient quantity is
  produced
• Pigovian Tax
• impose a tax on the good being produced equal to
  the marginal external cost at the efficient
  quantity

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Public Policy Solutions (cont.)

• A subsidy
• government pays a subsidy to not produce equal to
  the marginal external cost at the efficient
  quantity
• Tradable Permit System
• Government issues permits to produce equal to the
  efficient quantity and allows trading of the
  permits