Pollution, second-hand smoke and other side effects nobody pays for. Explore the language of externalities and the tools used to fix them.
These terms were extracted from Principles of Microeconomics by Dr. Emma Hutchinson, University of Victoria, eCampusOntario which is licensed under a Creative Commons Attribution 4.0 International License. Based on Principles of Microeconomics by OpenStax, licensed under CC BY 4.0.
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additional benefits reaped by third parties outside the production process when a unit of output is produced
When we add external benefits to private benefits, we create a marginal social benefit curve.
additional costs incurred by third parties outside the production process when a unit of output is produced
To do so, we must consider the external costs and benefits.
a market exchange that affects a third party who is outside or “external” to the exchange; sometimes called a “spillover”
The effect of a market exchange on a third party who is outside or “external” to the exchange is called an externality.
When the market on its own does not allocate resources efficiently in a way that balances social costs and benefits; externalities are one example of a market failure
Since the market did not naturally maximize societal welfare, the unaddressed externality results in a market failure.
a situation where a third party, outside the transaction, suffers from a market transaction by others
The club example from above is that of a negative externality.
a situation where a third party, outside the transaction, benefits from a market transaction by others
A positive externality occurs when the market interaction of others presents a benefit to non-market participants.
a market that only considers consumers, producers and the government, doesn’t include external agents
Private markets only consider consumers, producers and the government – the impacts on external parties is irrelevant.
costs that include both the private costs incurred by firms and also additional costs incurred by third parties outside the production process, like costs of pollution
This topic begins by discussing how firms may fail to take certain social costs, like pollution, into their planning if they do not need to pay these costs.
see externality
Because externalities affect other parties beyond those involved, they are sometimes called spillovers.
a tax levied on any market activity that generates negative externalities (costs not internalized in the market price)
A tax that addresses a negative externality by taxing the good instead of the actual external cost is called a Pigouvian Tax.
reduction or lessening, in this case the reduction of pollution
In analyzing the decisions of firms directly around emission or pollution, we use the abatement model.
a government program designed to cap the total level of emissions from firms by creating a market for pollution permits
A scheme where Firm 1 can buy pollution allowances from Firm 2 exists, and is called Cap and Trade.
a permit that allows a firm to emit a certain amount of pollution; firms with more permits than pollution can sell the remaining permits to other firms
If there was a way for Firm 1 to pay Firm 2 for some of its pollution allowance, then both parties could gain.
legal requirements that set limits on the permissible amount of pollutants, restrict the quantity of pollution that a firm emits
It decides to divide the abatement burden evenly between the two firms (450 each) so a pollution standard is set at 350 units.
a tax imposed on the quantity of pollution that a firm emits
Whereas with cap and trade, the government has to set the quantity of emissions, a pollution tax allows it to set the price.