6.2 Externalities

a. Define externalities. b. Explain (using graphs where appropriate) how in the presence of externalities, private markets do not take into consideration social costs or social benefits.

• The socially optimal quantity of a good occurs where the marginal social benefit of consuming the last unit equals the marginal social cost of producing that last unit, thus maximizing total economic surplus.
• Externalities are either positive or negative and arise from lack of well-defined property rights and/or high transaction costs.
• In the presence of externalities, rational agents respond to private costs and benefits and not to external costs and benefits.
• Rational agents have the incentive to free ride when a good is non-excludable.
• Enduring understanding POL-3: Private incentives can fail to account for all socially relevant considerations.

Explain (using graphs where appropriate) how public policies address positive or negative externalities.

• Policies that address positive or negative externalities include taxes/subsidies, environmental regulation, public provision, the assignment of property rights, and the reassignment of property rights through private transactions.
• Enduring understanding POL-3: Private incentives can fail to account for all socially relevant considerations.