1.3.2 Externalities

• An externality is the cost or benefit that affects a third party who did not choose to incur that cost or benefit
• A positive externality results in a cost for a third party.

  False
• Factory pollution is an example of a negative externality.
• Vaccinations provide herd immunity, which is a positive externality.
• Factory pollution is an example of a negative externality because it creates a cost for a third party.
• A negative externality leads to overproduction of goods.
• Place the following steps in the correct order to describe the impact of externalities on resource allocation:

  1️⃣ Identify the externality (positive or negative)

  2️⃣ Recognize the divergence between private and social costs/benefits

  3️⃣ Determine whether resources are over- or under-allocated
• Market failure occurs when resource allocation is not efficient due to externalities.
• Negative externalities lead to underallocation of resources.

  False
• What is a social cost in the context of externalities?

  Private costs plus third-party costs
• An externality leads to market failure because the market price does not reflect the full social costs and benefits.
• What does a social cost or social benefit differ from?

  Private cost or benefit
• Social cost includes private costs and the costs borne by third parties
• Vaccination leading to herd immunity is an example of a social benefit.
• What type of cost is incurred directly by the producer?

  Private cost
• Enjoying the use of a new car is an example of a private benefit
• An externality always leads to an efficient allocation of resources.

  False
• What is the definition of an externality?

  Cost or benefit for third party
• Vaccinations leading to herd immunity are an example of a positive externality
• What is an example of a negative externality?

  Factory pollution
• A negative externality results in a cost to a third party.
• Match the type of externality with its example:

  Positive externality ↔️ Vaccinations

  Negative externality ↔️ Factory pollution
• Arrange the effects of externalities on resource allocation in order:

  1️⃣ Negative externalities: Overallocation

  2️⃣ Positive externalities: Underallocation
• How do externalities lead to market failure?

  Divergence between costs/benefits
• A negative externality such as factory pollution leads to overallocation because private costs underestimate true costs
• Positive externalities result in the underallocation of resources.
• What causes market failure when externalities are present?

  Divergence between private and social costs/benefits
• Externalities lead to market failure by causing a divergence between private costs/benefits and social costs
• Negative externalities result in overproduction of goods.
• Positive externalities lead to underallocation of resources.
• Factory pollution is an example of a negative externality
• Vaccinations are an example of a positive externality
• What is the purpose of regulations in addressing externalities?

  Control harmful actions
• One drawback of regulations is that they may stifle innovation
• What is the effect of taxes on goods with negative externalities?

  Reduces harmful activities
• Subsidies are used to encourage the production or consumption of goods with positive externalities
• Steps in private negotiations to address externalities

  1️⃣ Identify affected parties

  2️⃣ Discuss costs and benefits

  3️⃣ Reach a voluntary agreement

  4️⃣ Implement the agreement
• Taxes on negative externalities generate revenue for the government.
• Private negotiations require clear property rights to be effective.
• Regulations ensure compliance but may be costly to enforce.