Chapter 5 Flashcards
Externalities: Problems and Solutions
Externality
Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so.
Market Failure
A problem that causes the market economy to deliver an outcome that does not maximize efficiency.
Negative Production Externality
When a firm’s production reduces the well-being of others who are not compensated by the firm.
Private Marginal Cost (PMC)
The direct cost to producers of producing an additional unit of a good.
Social Marginal Cost (SMC)
The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others.
Private Marginal Benefit (PMB)
The direct benefit to consumers of consuming an additional unit of a good by the consumer.
Social Marginal Benefit (SMB)
The private marginal benefit to consumers minus any costs associated with the consumption of the good that are imposed on others.
Negative Consumption Externality
When an individual’s consumption reduces the well-being of others who are not compensated by the individual.
Positive Production Externality
When a firm’s production increases the well-being of others but the firm is not compensated by those others.
Positive Consumption Externality
When an individual’s consumption increases the well-being of others, but the individual is not compensated by those others.
Internalizing the Externality
When either private negotiations or government actions lead the price to the party to reflect fully the external costs or benefits of that party’s actions.
Coase Theorem (Part 1)
When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity.
Coase Theorem (Part 2)
The efficient solution to an externality does not depend on which party is assigned the property rights, so long as someone is assigned those rights.
Holdout Problem
Shared ownership of property rights gives each owner power over all the others.
Free Rider Problem
When an investment has a personal cost but a common benefit, individuals will underinvest.
