Reference no: EM131174864

In the below scenario, if John won't change his loud morning departure, what can be a method to internalize the cost?

John, a computer engineer lives in a suburban neighborhood and rides his motorcycle to his work at 6:30 each morning. He innocently starts up his cycle at 6:30, and unknowingly wake up 10 neighbors, who individually curse his cycle and try to get another hour of sleep. John gives noise (cost) to his neighbors because he does not take this cost into account in making his decision. This is called external cost (John does not undertake this cost) of john’s action, or a negative externality. In this example, each of the neighbors would be willing to pay up to $5 a week to get rid of the morning motorcycle noise. John would be willing to push his motorcycle out of earshot before starting it up for a payment as low as $20 a week. In other words, the neighbors would be willing to pay total $50 to get rid of the noise, and John would be willing to accommodate them for $20. But they probably won’t make a deal because the negotiation and transaction costs are too high. Transaction costs are the costs of arranging contracts or transaction agreements between demanders and suppliers. Although the neighbors and John would all be better off if each neighbor paid $5 to push the motorcycle out of earshot before cranking it up, the total cost of gathering the required information, collecting the payments, and enforcing the agreement would be larger than the potential benefit. So nothing will change and the externality persists. It does not always take monetary payments to eliminate an externality. John will soon hear from someone that his 6:30 departure annoys his neighbor and decide to push the motorcycle to the end of their block (=internalizes the externality).