In the fifth episode of the Economic Lowdown Video Series, Scott Wolla, economic education specialist, explains externalities. Viewers will learn how costs and benefits sometimes affect bystanders and discover how taxes and subsidies can be used to "internalize" externalities.
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The government could place a 20 cent tax on each widget produced to ensure that the firm pays the actual cost of production—which is now two dollars and twenty cents, including the cost of the negative externality.
As a result of the higher cost of production, the firm will reduce its production of widgets thus reducing the level of pollution.
When you complete some post-high school training, you'll reap the benefits of your education in the form of better job opportunities, higher productivity and higher income.
A technical degree or college education will further enhance those benefits.
Although you might think you are the only one who benefits from your education, that isn’t the case.
The many benefits of your education spill over to society in general.
In other words, you can generate positive externalities.
For example, well-educated citizens are more likely to make good decisions when electing leaders.
In addition, more education leads to higher worker productivity and higher living standards for society in general.
Although education has many spillover benefits, providers of education do not receive the revenue they would earn if the full benefits of the transaction were internalized.
To state it differently, producers of education are not fully compensated for the benefits that spill over to society.
As a result, producers of education will likely under-produce education.
Encouraging Positive Externalities
Government can play a role in encouraging positive externalities by providing subsidies for goods or services that generate spillover benefits.
A government subsidy is a payment that effectively lowers the cost of producing a given good or service. Such subsidies provide an incentive for firms to increase the production of goods that provide positive externalities.
And, because the spillover benefits go to society, government subsidies are a way for society to share in the cost of generating positive externalities.
After all, society pays the taxes that fund the subsidies.
Regarding education, because the government subsidizes public education, a greater quantity of education is produced and consumed and society reaps the spillover benefits.
To summarize, the costs and benefits of transactions for goods and services are often contained between the producers and consumers, but sometimes costs and benefits spill over to third parties.
A negative externality exists when a cost spills over to a third party.
A positive externality exists when a benefit spills over to a third party.
Government can discourage negative externalities by taxing goods and services that generate spillover costs.
Government can encourage positive externalities by subsidizing goods and services that generate spillover benefits.
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