CHAPTER 10 Externalities and Public Goods

The costs of greenhouse gases are borne by everyone.

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Chapter Objective

Explore what happens when your choices have side effects on others.

• 10.1 Identifying Externalities

  Identify externalities and their consequences.

• 10.2 The Externality Problem

  Analyze how externalities lead markets to produce inefficient outcomes.

• 10.3 Solving Externality Problems

  Learn how to solve externality problems.

• 10.4 Public Goods and the Tragedy of the Commons

  Understand how to solve externality problems that arise when people can’t be excluded from using something.

The Earth is heating up, causing glaciers to melt and the sea level to rise. This has disrupted global weather patterns, leading to more extreme weather events such as floods and droughts. As a result, thousands of species face extinction as their habitats disappear. Humanity faces related threats, as climate change has led to declining crop yields. Scientists have suggested that if nothing changes, whole cities will eventually be submerged under water.

A leading cause of all this upheaval is rising greenhouse gases. To understand what’s going on, realize that nature has blessed our planet with a blanket of greenhouse gases that insulates us from the extreme temperatures in outer space. The problem is that this blanket is getting thicker, which is warming the Earth. The rise in greenhouse gases over the past 150 years is mostly due to burning fossil fuels that release greenhouse gases into the atmosphere.

But beyond the science, economists see an even deeper cause of global warming, and it’s rooted in a pervasive market failure. Here’s the problem: Whenever one of us decides to burn fossil fuels, the ensuing pollution affects all of us. This means that no individual person bears the full consequences of their choice to use fossil fuels. Because people fail to account for the harm they do to the well-being of their fellow citizens, they burn more fossil fuels than is in our collective best interest.

This type of problem extends well beyond global warming. In this chapter we’ll discover that when people don’t face the full costs and benefits of their actions, they’ll often make choices that ignore the interests of affected bystanders. Failing to resolve the tension between your private interest and society’s interest can lead markets, communities, and corporations to make bad choices.

But these problems are not inevitable, and in the second half of this chapter, we’ll dig into potential solutions, exploring ways in which you can change people’s incentives so that they make decisions that better serve society’s interests. The payoff is that you’ll have a set of tools you can use to generate better outcomes for your community, your company, and your planet.