Chapter 10 Journal

In this chapter, Mankiw begins to explain the concept of externalities, which is the effect of a transaction between a buyer and a seller on a third party. Externalities can be negative, meaning they are detrimental to the third party, or positive, meaning they are beneficial to the third party. These externalities create their own curves, called social-cost curves, that cause the socially optimal quantity to be greater than the equilibrium quantity. Ideally, the government wants to shift the supply or demand curves so that the equilibrium quantity is the same as the socially optimal quantity, and they do that by imposing either taxes, in the case of negative externalities, or subsidies, in the case of positive externalities. In some cases, those that are affected by externalities are able to solve the problem of the externality privately, i.e. without government intervention. For example, if a firm creates an externality for another firm, they could either merge or create a contract with each other in order to “internalize”, or alter the incentives, of that externality. This relates to the Coase theorem, which states that private parties can solve externalities on their own if they are able to bargain without cost. However, this theorem does not always prove to work out because bargaining can be costly and difficult for the parties involved, especially if there is a larger number of parties involved. If private parties are not able to deal with externalities by themselves, the government can internalize an externality using regulation or Pigovian taxes, which are taxes that are enacted to correct the effects of a negative externality.