 Markets sometimes fail to allocate resources efficiently – some of these market failures are called externalities  An externality is when a person engages in an activity that influences the well-being of a bystander who neither pays nor receives any compensation for that effect

 If impact on bystander is adverse – negative  If impact on bystander is beneficial – positive  In both cases, equilibrium is not efficient when there are externalities

◦ Externality causes cost to society to be larger than the cost to producers ◦ Social cost includes private costs to producers plus the cost to bystanders affected by externality ◦ Show this by putting social cost curve above the supply curve by the amount of the external cost

 Optimum quantity of production is where social cost curve intersects demand curve  Equilibrium quantity is larger than the socially optimal quantity, so… how do we fix this?

 We can tax the producer in order to shift the supply curve upward by the size of the negative externality  This gives buyers & sellers an incentive to take into account the external effects of their actions; a smaller quantity will be consumed

 When there is a positive externality, like education, the demand curve does not reflect the value to society of the good  Social value curve is above the demand curve and optimum quantity level is where social value curve intersects supply curve

 Positive externality requires a subsidy to move the demand curve to the right by the size of the externality (called social value curve)

 How could technology be a positive externality?  Tough to measure amount of technology spillover – debate on if government should encourage production of technology  Result is patent protection to encourage development of new ideas

 Can be positive or negative for either… examples?  Production externalities move social cost curve up or down from supply curve (private cost curve)  Consumption externalities move social value curve up or down from demand curve (private value curve)

 Don’t always need gov’t to intervene  Can be solved by moral codes/social sanctions  Charities can deal with externalities  Parties involved might enter into agreement that corrects the externality

 Proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own  Problem with private solutions: Transaction costs (either financially or logistically)

 2 major government options when there is an inefficient allocation of resources: 1. Command-and-Control Policies (Regulation) 2. Tradable Pollution Permits