SUMMARY

1. When pollution can be directly observed and controlled, government policies should be geared directly to producing the socially optimal quantity of pollution, the quantity at which the marginal social cost of pollution is equal to the marginal social benefit of pollution. In the absence of government intervention, a market produces too much pollution because polluters take only their benefit from polluting into account, not the costs imposed on others.

2. The costs to society of pollution are an example of an external cost; in some cases, however, economic activities yield external benefits. External costs and benefits are jointly known as externalities, with external costs called negative externalities and external benefits called positive externalities.

3. According to the Coase theorem, individuals can find a way to internalize the externality, making government intervention unnecessary, as long as transaction costs—the costs of making a deal—are sufficiently low. However, in many cases transaction costs are too high to permit such deals.

4. Governments often deal with pollution by imposing environmental standards, a method, economists argue, that is usually an inefficient way to reduce pollution. Two efficient (cost-minimizing) methods for reducing pollution are emissions taxes, a form of Pigouvian tax, and tradable emissions permits. The optimal Pigouvian tax on pollution is equal to its marginal social cost at the socially optimal quantity of pollution. These methods also provide incentives for the creation and adoption of production technologies that cause less pollution.

5. When a good or activity yields external benefits, or positive externalities, such as technology spillovers, then an optimal Pigouvian subsidy to producers moves the market to the socially optimal quantity of production.

6. Communications, transportation, and high-technology goods are frequently subject to network externalities, which arise when the value of the good to an individual is greater when a large number of people use the good. Such goods are likely to be subject to positive feedback: if large numbers of people buy the good, other people are more likely to buy it, too. So success breeds greater success and failure breeds failure: the good with the larger network will eventually dominate, and rival goods will disappear. As a result, producers have an incentive to take aggressive action in the early stages of the market to increase the size of their network. Markets with network externalities tend to be monopolies. They are especially challenging for antitrust regulators because it can be hard to differentiate between the natural progression of the network externality and illegal monopolization efforts by producers.