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Microeconomics

Externalities
Introduction
• Externalities, where one agent’s choice affects
others not involved in the transaction, can
prevent competitive markets from allocating
resources efficiently
• Externalities can be a benefit or a cost to other
parties
• Hence, externalities can be positive or negative
• When externalities occur, government policies
can improve economic efficiency.
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Externalities
• Externality: when an action affects someone with whom the
decision maker has not engaged in a related market
transaction
– Negative externality: when such an action harms
someone else
– Positive externality: when such an action benefits
someone else
• External cost: the economic harm that a negative externality
imposes on others
• External benefit: the economic gain that a positive
externality provides to others.

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Examples for Externalities
Negative externalities
• Cheap production at low environmental standards
• Plant closure that deprives supplying companies of
demand for their goods and services

Positive externalities:
• Vaccination
• Training workers if skills are transferable.

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Inefficiency in Competitive Markets
• When an externality is present, the private costs
and/or benefits of an activity to the party who
performs it differ from the social costs and/or
benefits of that activity
• When a consumption or production activity creates
an externality, competitive markets allocate
resources inefficiently, as not all costs and/or
benefits are taken into account by the decision
maker.

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Competitive Equilibrium with a
Negative Externality

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Competitive Equilibrium with a
Positive Externality

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Monopoly with a Negative Externality

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Remedies for Externalities
Private sector
• Negotiation – though bargaining costs and
initial allocation of property rights matters
Public sector
• Policies that internalize externalities
• Taxes, fees, subsidies
• Quantity controls
• Liability rules.
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Property Rights and Negotiation
Coase Theorem: if bargaining were frictionless, then
regardless of how property rights are assigned, voluntary
agreements between private parties would remedy the
market failures associated with externalities and restore
economic efficiency.

In reality, bargaining often is not frictionless:


• Negotiation of many residents with paper mill owner?
• Quantifying the benefits of education to wider society?
• Quantifying the risk of non-vaccination to others?
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Property Rights and Negotiation

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Property Rights and Negotiation

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Limitations of Private Bargaining
• Bargaining can be impractical, requiring substantial
time and effort
• The assignment of property rights may be ambiguous
• Parties may have limited information about each
others’ costs and benefits
• Efficient contracts may be difficult to monitor and
enforce.

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Policies Supporting Markets
• When private negotiations fail to remedy the market
failures associated with externalities, appropriate
government policies can potentially improve economic
efficiency
• In some situations, governments can address
externalities by helping the private sector create the
necessary markets
– Establish clear property rights, pass laws that protect
those rights, and enforce contracts
– Governments can even create and operate a market.

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Quantity Controls
Socially efficient
Emission standard:
legal limit on the
amount of noise or
pollution that a
person or company
can produce when
engaged in a
particular activity.

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Taxes, Fees, and Subsidies
• Pigouvian
taxation: the use
of taxes or fees to
remedy negative
externalities
• Pigouvian
subsidization: the
use of subsidies to
support positive
externalities.

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Liability Rules
Liability rule: a
legal principle
requiring a party
who takes an action
that harms others
to compensate the
affected parties for
some or all of their
losses.

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Pitfall for Liability Rules and
Pigouvian Taxes
Efforts to correct
private incentives
can lead to high
levels of inefficiency
because they might
lead the affected
parties to engage in
wasteful behaviors.

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