Lecture 4

Market Failure, Public Goods, Externalities

Externalities and Government Policy

PROFESSOR OF FINANCE
ANDREEA STOIAN, PHD
DEPARTMENT OF FINANCE AND CEFIMO
BUCHAREST UNIVERSITY OF ECONOMIC STUDIES
 Air pollution

Smoke

Smog
Externalities Acid rain
Classification

When externalities prevail, a third party, other than the buyers or

Negative externalities (external costs) are

Market prices do not accurately reflect either the marginal social

costs to third party other than the buyers

Externalities are costs or benefits of market transactions not

of the sellers of an item not reflected in
the market price

the sellers is affected by its production or consumption.

benefit or all the marginal social cost of a traded item

Positive externalities (external benefits)
are benefits to the third party other than
the sellers or the buyers of a good or
service not reflected in the price
reflected in prices.

Pecuniary externalities the effects of an

increase (decrease) in the price of a good
on existing consumers as a result of
changes in the demand or supply of a good
Externalities vs. Efficiency

Externalities Efficiency

MC(MB)MSC(MSB)
Internalization of Externalities
Corrective taxes Method of internalizing negative externalities
•Is designed to adjust the marginal private cost of a good or service in such way to externalize the externality
•The tax must equal the marginal external cost, T=MEC
•S’=MCP+T

Corrective subsidies Method of internalizing positive externalities

•Is a payment made by government to either buyers or sellers of a good so that the price paid by consumers is reduced
•The payment must equal the marginal external benefit (MEB)
•D’=MPT+S

The Coase Theorem Property right to resource use

•Governments, by establishing the rights to use resources can internalize the externalities
•The users who are initially granted the right are better off, because they own a valuable property right that can either be used or exchanged
•The assignment of the property right by the government affects the distribution if income between the two parties using the resource
Negative externalities and corrective
taxes
Positive externalities and corrective
subsidies