ABSTRACT
This chapter begins with a discussion of the nature of and the market failure associated with externalities, and turns to several possible solutions to this market failure. An externality is a cost or benefit of an economic activity that accrues to a person not directly involved in that activity. These costs or benefits are also known as 'external costs' or 'external benefits'. The marginal benefit to society of an additional unit of the good is known as the marginal social benefit. The chapter examines the effect of positive externalities and negative externalities in turn. It considers a positive consumption externality and a negative production externality. A number of solutions exist to correct the deadweight loss arising from an externality. The chapter also considers three solutions: the Coase Theorem; taxes and subsidies; and standards and regulations. It discusses how a government could use taxes and subsidies to indirectly implement the socially optimal outcome.
