Externalities: a side effect of an economic decision that affects someone who is not a part of that decision

• positive externalities: consequences of economic decisions that are beneficial to those who are affected by them
  

• breath mints - consuming breath mints freshens your breath, makes others who have to deal with it better off, reduces negative externality of eating garlic, for example
• flower garden - growing a flower garden brightens your own home, increases its value, and on a large enough scale, gardens could drive up the value of all properties in your neighborhood
• immunization - immunization rids you of the possibilities for contracting a disease, but it also prevents you from being a carrier of it and giving it to someone else

• negative externalities : limited budget, limited time, limited available information - shown through the budget line

• smog - when a factory produces goods, it often emits pollution, which causes harm to those that live around the factory and breath the polluted air that it inadvertantly produces
• loud music - when you play your music loudly at 3 AM, you might enjoy it, but someone trying to sleep is hurt by your decision to play music, as he or she probably is having a hard time sleeping
• reckless driving - it might be enjoyable for you to drive your car at high speeds, but such driving causes negative externalities in that it makes the road more dangerous and increases the probability that your car might end up in a collision with another

Traditional View of Externalties: in competitive, pareto-efficient equilibria, too many activities occur that yield negative externalities, while too few activities occur that yield positive externalities

MSC = marginal social cost

MPC = marginal private cost

P = MV: price equals marginal value or benefit

- at a competative equilibrium, firms will produce at the quantity where marginal private cost equals marginal value


- efficient outcome = quantity where marginal social cost equals marginal vaue

- this gives rational for taxing private producers who cause externality - in the hopes that paying taxes will offset the negative effects of externalities

Ronald Coase: 1960's economist who reevaluated traditional theories on externalities. In an article titled, "The Problem of Social Cost," Coase outlined what has now been dubbed the Coase Theorem.

• property rights: determines who gets to make the economic decisions - eliminates controversy over who makes decisions
• transaction costs: the costs associated with reaching an agreement and enforcing it

Coase Theorem: If property rights are clearly defined, and if transaction costs are negligable, then, no matter who holds the property rights

1. the allocation of resources will be Pareto efficient

- if resources weren't allocated efficiently, with no transaction costs, people would work toward efficient allocation

2. except for wealth effects, the allocation of resources does not depend on who holds the property rights

- when settling the problem of the externality, whoever holds the property rights can determine the loss or gain of wealth
- wealth effects can change the allocation of monetary resources, and thus, the allocation of resources depends on who holds the property rights

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