Chapter+10+Kathy+L





 Are externalities good or bad?



When firms produce products from their factories, they often-times create pollution. Pollution is, in fact, a type of externality. What are these? Externalities make the society inefficient.
 * Externality:** the uncompensated impact of one person's actions on the well-being of a bystander.

Going back the example of pollution, why would pollution be created in the first place? It's because the company owner does not consider the external effects of their decision when they resolve how much to demand or supply. More specifically, in this case, the company owner only took in consideration the private cost but not the external costs (costs that may be needed to prevent pollution).



__Externalities are strictly divided into two: Negative and positive.__

(The green supply curve above indicates the Social Cost (private cost and external cost))

Pollution is an example of a negative externality. Negative externalities are overproduced. Thus, we have more of these (-) externalities than is socially desired. We surely have more pollution than we desire--if we desire it at all, that is.

The social cost of a good exceeds the private cost. Thus, this makes the optimal(ideal) quantity smaller than the equilibrium quantity. (ex) Pollution: for each unit of steel produced, certain amount of smoke enters into the air and imposes health risk for people. Cost of society > cost to steel producers. Therefor, (-) externalities produce more than socially desirable. Government steps in! They try to “internalize externality” by imposing taxes on steel producers for each ton of steel sold. The price of steel would increase, and the supply curve would shift upward by the size of the tax. The amount of gas produced would become the social optimum quantity of steel.



Positive externalities are under-produced. In other words, we have less than is socially desired. Some examples of positive externalities may be education or historical buildings. Education increases our knowledge so we want more of it, and historical buildings are beautiful so they brighten up our neighborhood. Likewise, we would want more of these, wouldn't we? The social value of the good exceeds the private value. Thus, this makes the optimal(ideal) quantity larger than the equilibrium quantity. (ex) Education: Education allows a society to have lower crime rates, encourage the development of technological advances, and create more informed voters(thus, a better government). Value to society > private value. Therefor, (+) externalities create less than is desirable. Government steps in! They would “internalize externality” by encouraging to produce more positive externality. In this case, they would subsidize through public schools or government scholarships.  When we do have externalities, we should find a way to take care of it? Remember, even if it may be a 'positive' externality, it still makes the society inefficient so we do have to fix it somehow. We call the 'fix it somehow' process **internalization**. Thus, we 'internalize' externalities.

There are private **solutions** to externalities. One well known private solution is called the //Coase Theorem//. This is the proposition that if private parties can bargain without the allocation of resources, they can solve the problem of externalities on their own. However, these types of private solutions do not always work. Why so? Well, we must understand the transactional costs. These are the costs that's involved with the process of private solutions such as bargaining. For instance, if you had to talk to another person to bargain, and decided to go to a coffee shop, the money used to buy a cup of coffee can also be considered as the transactional cost.

Government can also be involved in the process of internalization. First one is called the **corrective tax**. Corrective taxes are designed to induce the private dcision makers to take account of the social costs that arise form a negative externality. The reason why economists would prefer the corrective tax is that it can reduce pollution more efficiently. It requires each firm to cut down, for example, pollution by the same amount. Another type is **trade-able pollution permits**. This is different from the corrective tax because, for example, a factory can decide to pollute more but they would have to pay and buy the pollution permits. Thus, factories would decide whether or not to save money by polluting less and buying less of pollution permits or vice versa.

  Give an example of aa negative externality and a positive externality. Explain why market outcomes are inefficient in the presence of externalities.

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 * Coase Theorem:** the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own
 * Corrective Tax:** a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality
 * Externality:** the uncompensated impact of one person’s actions on the well-being of a bystander
 * Internalizing the Externality:** altering incentives so that people take account of the external effects of their actions
 * Transaction Costs:** the costs that parties incur in the process of agreeing to and following through on a bargain