Suppose you and I are identical. We put up fireworks in our adjacent backyards on a national holiday, and we can both enjoy each other's fireworks.
a. Can you identify an externality?
b. Can you identify any missing markets?
c. Do you think we will provide more or less than the efficient number of fireworks?
d. If we could vote on a tax to be imposed on us fund fireworks in our back yards, would we vote for a lump sum tax (imposed equally on both of us) that will cause more fireworks to be put up than what we would put up on our own?
e. Suppose instead the government implements a Pigouvian subsidy. How would the number of fireworks compare to what would happen in (d)? How much of a subsidy would you think we would both get for every dollar of fireworks each of us individually buys?

What will be an ideal response?

a. The externality arises from the fact that I produce benefits for you and you produce benefits for me -- but neither you nor I are considering the benefits we impose on the other when we choose our fireworks level.


b. The missing markets are the markets for the goods we are producing for the other. I produce fireworks for you, and you produce fireworks for me -- but there is no market to price these.


c. We will produce an inefficiently small number of fireworks because of the positive externality.


d. We would both be better off if the efficient quantity were produced -- and thus, if we could commit to both be taxed, would vote for an efficient level of that tax to fund an efficient level of fireworks.

e. The efficient Pigouvian subsidy would implement the efficient level of fireworks -- just as in (d). Since we are identical, the subsidy would match our spending dollar for dollar.