1. 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.

  2. 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.

  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. Goods may be classified according to whether or not they are excludable and whether or not they are rival in consumption.

  7. Free markets can deliver efficient levels of production and consumption for private goods, which are both excludable and rival in consumption. When goods are nonexcludable or nonrival in consumption, or both, free markets cannot achieve efficient outcomes.

  8. When goods are nonexcludable, there is a free-rider problem: some consumers will not pay for the good, consuming what others have paid for and leading to inefficiently low production. When goods are nonrival in consumption, they should be free, and any positive price leads to inefficiently low consumption.

  9. A public good is nonexcludable and nonrival in consumption. In most cases a public good must be supplied by the government. The marginal social benefit of a public good is equal to the sum of the individual marginal benefits to each consumer. The efficient quantity of a public good is the quantity at which marginal social benefit equals the marginal cost of providing the good. Like a positive externality, marginal social benefit is greater than any one individual’s marginal benefit, so no individual is willing to provide the efficient quantity.

  10. One rationale for the presence of government is that it allows citizens to tax themselves in order to provide public goods. Governments use cost-benefit analysis to determine the efficient provision of a public good. Such analysis is difficult, however, because individuals have an incentive to overstate the good’s value to them.