1. Chapter 5 EXTERNALITIES
When actions spillover to affect
3rd parties

2. 5 Chapter Outline and Learning Objectives CHAPTER
5.1
Externalities and Economic Efficiency
Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.
5.2
Private Solutions to Externalities: The Coase Theorem
Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality.
5.3
Government Policies to Deal with Externalities
Analyze government policies to achieve economic efficiency in a market with an externality.
5.4
Four Categories of Goods
Explain how goods can be categorized on the basis of whether they are rival or excludable, and use graphs to illustrate the efficient quantities of public goods and common resources.

3. Externality
A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

4. A sign of market failure
EXTERNALITIES
A sign of market failure
So far, we have only looked at situations where our decisions have had no influence on others
What happens if our actions do affect others, yet we don’t take this into account?

5. Externalities
EXTERNALITIES - Results of consumption/production decisions that affect 3rd parties (ie. Not those consuming/producing)
Externalities - could be positive (external benefit)
or negative (external cost)

6. Why do externalities matter?
Inefficient allocation of resources occur when externalities are present.
Examples:
1) Negative externality (pollution, noise)
2) Positive externality (education, health care)

7. Solving the Externalities Problem: Private Solutions
Coase Theorem: If transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities.

8. Solving the Externalities Problem
What can we do to solve this problem?
Property Rights - social arrangements that govern the use,
ownership, and disposal of factors of production, goods and services
- these are legally enforceable
2) Also, we could INTERNALIZE THE EXTERNALITY
This is done by adjusting the marginal cost/benefit of a
good/service so efficient allocation is achieved.
2 ways to do this:
1) Corrective Tax (Pigovian Tax)
2) Corrective Subsidy (Pigovian Subsidy)

9. Four Categories of Goods

10. Four Categories of Goods
Private good. A good that is both rival and excludable.
Public good. A good that is both nonrivalrous and nonexcludable.
Free riding Benefiting from a good without paying for it.
Quasi-public goods. Goods that are excludable but not rival.
Common resource. A good that is rival but not excludable.

11. How does corrective tax help reduce negative externality
How does corrective tax help reduce negative externality? Will do example in class. How does subsidy help increase positive externality? Will do example in class.

12. Know these Definitions
Coase theorem
Command-and-control approach
Common resource
Excludability
Externality
Free riding
Market failure
Pigovian taxes and subsidies
Private benefit
Private cost
Private good
Property rights
Public good
Rivalry
Social benefit
Social cost
Tragedy of the commons
Transactions costs