Chapter 16, Problem 1RQ

To determine

To ascertain:Difference between the two situation and reason for inefficient allocation of resources in second situation but not in first.

Answer to Problem 1RQ

First situation is not externality as property rights are undefined while second situation is externality.

Explanation of Solution

Externality arises when benefits or negative impact of a person is borne or enjoyed by other person without any aid or compensation. This usually occurs because property rights are not defined properly. One of the ways to assign property rights is bidding. It is a process in which the person who gives the maximum value to a commodity gets the right of the commodity. The bid gets higher and higher due to competition not because on any negative damage done to environment.

On the other hand, in the case of pollution, the social cost is higher than the private cost. Environmental degradation causes negative externalities on other firms, which may resort to taking remedial actions. It is very difficult to quantify the cost of externality and to penalize the polluting firms until the property rights are rigidly defined. Price mechanism does not offer a solution to this problem. In negative externality, the optimum production level is lower than the individual optimum output.

Economics Concept Introduction

Introduction:

Externality is a situation in which one’s activity directly or indirectly affects other party. There are two types of externality: Positive and negative externality. Positive externality is a situation in which action of one’s party gives benefit to other parties without asking for any rebate. Negative externality is a situation in which actions of one party harms other parties.