1. Externalities - Definition and examples

An externality arises when a firm or person engages in an activity that affects the wellbeing of a third party, yet neither pays nor receives any compensation for that effect. If the impact on the third party isadverse, it is called a externality.

The following graph shows the demand and supply curves for a good with this type of externality. The dashed drop lines on the graph reflect the market equilibrium price and quantity for this good.

Adjust one or both of the curves to reflect the presence of the externality. If the social cost of producing the good is not equal to the private cost, then you should drag the supply curve to reflect the social costs of producing the good; similarly, if the social value of producing the good is not equal to the private value, then you should drag the demand curve to reflect the social value of consuming the good.

Demand

Supply

PRICE (Dollars per unit)

QUANTITY (Units)

Demand

Supply

With this type of externality, in the absence of government intervention, the market equilibrium quantity produced will begreater than the socially optimal quantity.

Which of the following generate the type of externality previously described?Check all that apply.

Your roommate Kevin has bought a bird that keeps you up at night with its chirping.

The city where you live has granted a permit to put a movie theater in your neighborhood, causing traffic jams at night and on weekends.

A leading electronics manufacturer has discovered a new technology that dramatically improves the picture quality of plasma televisions. Firms of all brands have free access to this technology.

Hilary has planted hundreds of flowers in her front yard, beautifying the neighborhood both for herself and for her neighbors.