Chapter 10

• Externality

  – The uncompensated impact of one person’s actions on the well-being of a bystander
• Negative externality

  – Impact on the bystander is adverse
• Positive externality

  – Impact on the bystander is beneficial
• Negative externalities

  – Exhaust from automobiles – Barking dogs
• Positive externalities

  – Restored historic buildings

  – Research into new technologies
• Social cost

  • Private costs of the producers (supply)

  • Plus the costs to those bystanders affected adversely by the negative externality
• Social cost curve is above the supply curve

  • Takes into account the external costs imposed on society
• Optimum quantity produced

  • Maximize total welfare

  • Smaller than market equilibrium quantity
• Social value curve

  • Above the demand curve
• Command-and-control policies

  – Regulate behavior directly – Regulation
• Market-based policies

  – Provide incentives so that private decision makers will choose to solve the problem on their own
• Regulation

  – Regulate behavior directly: making certain behaviors either required or forbidden

  – Cannot eradicate pollution
• Corrective taxes (Pigovian taxes)

  • Induce private decision makers to take account of the social costs that arise from a negative externality
• Tradable pollution permits

  – Voluntary transfer of the right to pollute from one firm to another
• The Coase theorem

  – If private parties can bargain without cost over the allocation of resources
• Internalizing the externality - altering incentives so that people take into account the external effects of their actions
• Industrial policy

  – Government intervention in the economy that aims to promote technology-enhancing industries
• Patent law

  – Protect the rights of inventors by giving them exclusive use of their inventions for a period of time
• Transaction costs

  • Costs that parties incur in the process of agreeing to and following through on a bargain