Economics – Dr. Sauer
Chapter 3 Reading Guide: Government I
I. Negative Externalities
An externality is
Technical definition: an externality is an uncompensated impact on a third party. Externalities can be
positive or negative.
What typically happens when an activity has a small private cost and a large social cost?
What will markets do to fix externality problems?
Examples of negative externalities:
A negative externality you faced in your life:
In a market economy, government policy is one way of fixing externality problems.
Externalities are the reason for many types of policy suggestions.
children on airplanes:
mobile phone use:
II. Positive Externalities
Give some examples of positive externalities:
Think of a positive externality from your life:
Explain how cigarette smoking has both positive and negative externalities associated with it.
III. Dealing with Externalities
Explain how regulations can correct externalities.
Explain how taxes can correct externalities.
Explain why taxing behaviors that generate negative externalities can create good incentives.
What are some of the problems associated with taxing externalities?
C. Private Solutions
Explain the 3 insights of Nobel Prize winner Ronald Coase:
The parties involved in the externality have an incentive to come to an agreement on their
The solution will be the same, regardless of who starts with the property right.
In order for a private solution to be reached, transaction costs have to be low.
IV. Governments are Needed to Make Markets Possible in the First Place
Governments are needed to
set the rules:
define/protect property rights:
Explain the patent system:
provide justice system:
provide public goods:
V. Public Goods
Public goods have two characteristics:
Explain how the free-rider problem is present in public goods.
Parks / Open Space:
VI. Governments Redistribute Wealth
In order to make markets possible, deal with externalities, and provide public goods, governments
need to raise money.
What does economics tell us about how income and wealth should be distributed? Explain using Nobel
Prize winner Amarty Sen’s story.
According to economists, should governments protect people from themselves?
In your own words, summarize the main points of this chapter.