Summary

  1. Externalities impose costs or benefits on a third party not directly involved in an economic transaction. Without market intervention, both negative and positive externalities result in inefficient market outcomes. In an efficient market, firms produce where the market demand for the good equals the social marginal cost. [Section 17.1]

  2. Regulators can use quantity- or price-based interventions to fix externalities and push the market equilibrium toward the efficient outcome. Pigouvian taxes (or subsidies) are a tax (or subsidy) on the production or consumption of a good. The simplest form of a quantity-based intervention is a quota. Whether a price-based intervention like a Pigouvian tax or a quantity-based intervention like a quota should be used depends on the relative steepness of the marginal abatement and external marginal cost curves. [Section 17.2]

  3. The Coase theorem predicts that in the absence of transaction costs, negotiation among economic actors will lead to efficient outcomes regardless of who holds the property rights, and is used as the basis for a frequently used strategy to combat pollution: tradable permits. [Section 17.3]

  4. All public goods are characterized by two properties. First, public goods are nonrival, meaning one consumer’s enjoyment of the good does not diminish another’s enjoyment of it. Second, public goods are nonexcludable, that is, once a public good is on the market, it is impossible to prevent people from consuming it. Because of these two properties, public goods create a free-rider problem in which consumers want to freely consume, or free-ride, the public good that others have provided. Common resources are a special class of public goods that are rival but nonexcludable. The tragedy of the commons affects common resources, which are used more intensively than users would prefer if they could coordinate their actions. [Section 17.4]