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17.19 Externalities and Public Goods

Some economic transactions have effects on individuals not directly involved in that transaction. When this happens, we say there is an externality present. An externality is generated by a decision maker who disregards the effects of his actions on others. In the case of a positive externality, the individual’s actions increase the welfare of others (for example, research and development by firms). In the case of a negative externality, an individual’s actions decrease the welfare of others (for example, pollution).

Economic outcomes are not efficient when externalities are present. So the government may be able to improve on the private outcome. The possible remedies are as follows:

  • Subsidies (in the case of positive externalities) and taxes (in the case of negative externalities)
  • The creation of markets by the government

If people are altruistic, then they may instead take into account others’ welfare and may internalize some of the effects of their actions.

We typically see externalities associated with nonexcludable goods (or resources)—goods for which it is impossible to selectively deny access. In other words, it is not possible to let some people consume the good while preventing others from consuming it. An excludable good (or resource) is one to which we can selectively allow or deny access. If a good is nonexcludable or partially excludable, there are positive externalities associated with its production and negative externalities associated with its consumption.

We say that a good is a rival if one person’s consumption of the good prevents others from consuming the good. Most of the goods we deal with in economics are rival goods. A good is nonrival if one person can consume the good without preventing others from consuming the same good. Knowledge is a nonrival good.

If a good is both nonexcludable and nonrival, it is a public good.

Key Insights

  • When externalities are present, the outcome is inefficient.
  • The market will typically not provide public goods.