Question

Does the phenomenon of externalities strengthen the argument that we should rely upon the “invisible hand” of the marketplace, or does it weaken that argument?

Sheryl sits on her patio and plays her guitar while her neighbors are outside. Sheryl neither pays nor receives any compensation for playing her guitar. Under what condition does her guitar-playing give rise to a positive externality?

To produce honey, beekeepers place hives of bees in the fields of farmers. As bees gather nectar, they pollinate the crops in the fields, which increases the yields of these fields at no additional cost to the farmer. What might be a reasonable private solution to this externality, and how might the solution be reached?

Answer 1

in the presence of externality, the invisible hand argument for optimum allocation fails as there is a divergence between private and the social cost. in the presence of extremely marginal external cost and marginal external benefit do not get captured in the cost and benefit structure and thus lead to sub-optimal outcomes.

her guitar playing will give rise to positive externality when the neighbor receives positive benefit/utility by listening guitar by Sheryl. to correct this positive extranality neighbor must pay Sheryl a compensation for receiving positive utility by listening guitar.

the reasonable private solution for the positive externality that increases the yield of the farmer because of bees pollination is to pay to the beekeepers a price equals the marginal external benefit arising because of increased production. the solution can be reached by the mutual agreement between both the parties or simply merge the two firms in one so that benefit is internalized to the new merged firm.