1. An externality is defined as a benefit or cost that is imposed on a third party, such as society, other than the producer or consumer of a good or service, or, more simply, an economic side effect. The more of a product that is consumed or produced, the more of an externality that results. When discussing externalities in general terms, positive externalities refer to the benefits and negative externalities refer to the costs associated with the production or consumption of a good or service.
Public goods are one of the more common examples of positive externalities. Public goods are goods which are difficult to exclude people from benefiting from or from getting a free ride. Public goods, such as national defence, clean water, clean air, law enforcement, etc., are generally good for most, if not all of society.
Negative externalities exist in many situations. One of the most common examples is that of pollution. In these situations, the producer and consumer finance the goods produced but society must bear the cost of pollution that is introduced into the environment as a by-product and is thus a negative externality.
Using the above mentioned example of negative externality, pollution, a steel producing firm might pump pollutants into the air. While the firm has to pay for electricity, materials, etc., the individuals living around the factory will pay for the pollution since it will cause them to have higher medical expenses, poorer quality of life, reduced aesthetic appeal of the air, etc. Thus the production of steel by the firm has a negative cost to the people surrounding the factory-a cost that the steel firm doesn't have to pay.
2. Negative externalities are a property rights problem. Who owns the air that the steel mill pollutes? Ronald Coase put forth the solution which is known as the Coase Theorem: "Under perfect competition, once government has assigned clearly defined property rights in contested resources and as long as...
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