Externalities - Public Choice Economics Study Guide

This is Section 2 of Mr. Stolyarov's free Public Choice Economics Study Guide. See all sections here.

Question 8: Define "externality." Distinguish a positive externality from a negative externality.

Answer 8: An externality occurs when the complete benefits and/or costs of a particular decision are not fully taken into account by the decision-maker, often because the price system does not reflect the costs and/or benefits that a decision imposes on parties external to that decision. A positive externality occurs when an action has benefits to people other than the actor, and these benefits are not captured by the actor. A negative externality occurs when an action imposes costs on people other than the actor, and these costs are not borne by the actor.

Question 9: Give an example of a negative externality.

Answer 9: A negative externality may occur when a widget-making factory pollutes the air around it and leads to illness or property damage on the part of nearby inhabitants. If the widget producer only considers the price he may be able to receive per widget on the market, then he will not take into account the external cost of the damage done to people in the vicinity by the air pollution. In this case, the widget producer will only think of his own marginal benefits and costs in deciding whether to produce the next widget. He will not think of the external costs.

Question 10: Give an example of a positive externality.

Answer 10: If a person makes conspicuous improvements to his house, this will raise the property value of his home, but it will also raise the property values of surrounding houses by smaller amounts. The owner of the house, however, often only captures the benefits of his own house's increase in value, while the benefits of neighboring houses increasing in value are captured by others who own them. Thus, the total marginal benefit from improving the house is greater than the marginal benefit to the house's owner.

Question 11: What solutions did A. C. Pigou propose for negative and positive externalities?