[Mankiw principles of economics 10] 10.Externalities

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This video explains the concept of externalities in economics, which are the unseen side effects of actions that impact a bystander's well-being without compensation [01:05].

Here's a breakdown of the key points:

Types of Externalities

Negative Externalities: These have an adverse impact on bystanders. A classic example is pollution from a factory, where the cost of pollution is not factored into the factory's private costs [01:29]. This leads to overproduction (e.g., 25 tons of paper instead of the socially optimal 20 tons) because the market ignores the true social cost [02:16, 03:04].

Positive Externalities: These have a beneficial impact on bystanders. Getting a flu shot is an example; it not only benefits the individual but also reduces the likelihood of others getting sick [01:31, 03:28]. Markets tend to underproduce goods with positive externalities (e.g., 20 flu shots instead of the socially optimal 25) because the extra benefits to others aren't rewarded [03:53].

The Core Problem: Externalities lead to market inefficiency. Negative externalities result in a market quantity greater than what is socially desirable, while positive externalities result in a market quantity less than what is socially desirable. The goal is to "internalize the externality," meaning to adjust incentives so that decision-makers bear the true costs or benefits of their actions [04:16].

Government's Toolkit (Public Solutions) Governments can address externalities through:

Command-and-Control: Direct regulation, such as setting limits on pollution [04:55].

Market-Based Policies: These align private incentives with social efficiency. Examples include:

Corrective Taxes (Pigovian Taxes): Taxes designed to make polluters account for the social costs of their negative externality [04:55, 05:24].

Tradable Pollution Permits: A system where a total pollution limit is set, and companies can buy and sell permits to pollute. This allows pollution reduction to occur at the lowest possible cost to society [05:46].

Solving It Ourselves (The Coase Theorem) The Coase Theorem suggests that if private parties can bargain over resources without cost, they can solve externality problems on their own, regardless of who initially holds the legal rights [06:39]. This works when transaction costs are low, as illustrated by examples where neighbors can negotiate payments to resolve issues like loud music [06:56, 07:30]. However, bargaining can fail due to transaction costs, stubbornness, or coordination problems when many parties are involved [07:56].

In essence, externalities cause market inefficiency, but governments and sometimes private parties can implement solutions like taxes, permits, or bargaining to internalize these hidden costs and benefits, leading to more efficient outcomes for society [08:34].