Chapter 10 Summary

Chapter 10 introduced the first type of market failure (that is, when a market doesn’t allocate resources efficiently) discussed in detail. This market failure is known as an externality and describes a situation in which the transaction that takes place in a market has some influence on a bystander (i.e. someone who is NOT the buyer or seller) that is not considered in the price of the transaction. If this harms the bystander, it is a negative externality; if it helps them, it is a positive externality. Examples of externalities include pollution—because it harms everyone, but the producers (or consumers) of goods or services that pollute don’t pay for this harm or consider it in their costs, too many polluting activities take place. The government, through methods such as emissions limits or a tax, can help to rectify this inefficiency. By adding the cost of pollution to the supply, we can see that the true cost of a polluting good is higher than the cost to the firm, and therefore the optimum quantity is lower and the optimum price is higher. Technological spillover is a positive externality and can be represented by shifting the supply curve down: the cost to the public is less than the cost to the firm. The government should tax goods that have a negative externality to reduce the size of the market and cover the public cost of the good, while the government should subsidize goods that have a positive externality.