Chapter 5 externalities
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Chapter 5 EXTERNALITIES. When actions spillover to affect 3 rd parties. 5. CHAPTER. Chapter Outline and Learning Objectives. Externality. A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. EXTERNALITIES.

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Chapter 5 externalities


When actions spillover to affect

3rd parties

Chapter 5 externalities



Chapter Outline and Learning Objectives


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


  • 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?


  • 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)

Why do externalities matter
Why do externalities matter?

  • Inefficient allocation of resources occur when externalities are present.


1) Negative externality (pollution, noise)

2) Positive externality (education, health care)

Solving the externalities problem private solutions
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.

Solving the externalities problem
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


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)

Four categories of goods
Four Categories of Goods

Four categories of goods1
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.

Chapter 5 externalities

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.

Know these definitions
Know these Definitions

Private cost

Private good

Property rights

Public good


Social benefit

Social cost

Tragedy of the commons

Transactions costs

Coase theorem

Command-and-control approach

Common resource



Free riding

Market failure

Pigovian taxes and subsidies

Private benefit