Takeaway

In a free market, the quantity of goods sold maximizes consumer plus producer surplus. When the consumers and producers bear all the significant costs and benefits of trading, the market quantity is also the efficient quantity. But when there are external costs or benefits, the market quantity is not the efficient quantity. If it doesn’t bear all the costs of pollution, an electricity generator will emit too much pollution. If a person doesn’t receive all the benefits of a flu shot, he or she will choose too few flu shots.

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There are three types of government solutions to externality problems: taxes and subsidies, command and control, and tradable allowances. Market prices do not correctly signal true costs and benefits when there are significant external costs or benefits. Taxes and subsidies can adjust prices so that they do send the correct signals. When external costs are significant, the market price is too low, so an optimal tax raises the price. When external benefits are significant, the market price is too high, so an optimal subsidy lowers the price.

Command and control solutions can work but are often high-cost because they are inflexible and do not take advantage of differences in the costs and benefits of eliminating and producing the externality.

The Coase theorem explains that the ultimate source of the externality problem is too few markets. If property rights can be clearly defined and transaction costs reduced, then markets in the externality will solve the problem and will do so at the lowest cost. In recent years, successful markets have been created in the right to emit sulfur dioxide, and new markets are being used to reduce the gases that contribute to global warming.