POL-3.A—a. Define externalities. b. Explain (using graphs where appropriate) how in the presence of externalities, private markets do not…

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.