Chapter 10: Externalities

Chapter 10 talked about externalities. When a transaction between a buyer and seller directly affects a third party, the effect is called an externality. If an activity yields negative externalities, such as pollution, the socially optimal quantity in a market is less than the equilibrium quantity. If an activity yields positive externalities, such as technology overflow, the socially optimal quantity is greater than the equilibrium quantity. Governments pursue various policies to fix the inefficiencies caused by these externalities. Sometimes the government prevents socially inefficient activity by regulating behavior. Other times it internalizes an externality by using corrective taxes. Another public policy is to issue permits. A such case is when government issues a limited number of pollution permits. The result of this policy is pretty much the same as imposing corrective taxes on the polluters. Those affected by externalities can sometimes solve the problem privately. For instance, when one business imposes an externality on another business, the two businesses can internalize the externality by merging. Alternatively, the interested parties can solve the problem by negotiating a contract. According to the Coase theorem, if people bargain without cost, then they can always reach an agreement in which resources are allocated efficiently. In many cases, however, reaching a bargain among the many interested parties is difficult, so the theorem does not apply to all cases. Overall, I would give this chapter a 1/3 difficulty rating because it was easy understanding how externalities work and what the government can do to internalize the externality.