Final answer:
The three-step recipe to analyze externalities involves determining the negative externality, analyzing its impact on equilibrium, and identifying the equilibrium price and quantity.
Step-by-step explanation:
- Determine the negative externality in the situation by considering all parties impacted.
- Analyze how taking the externality into account affects the equilibrium price and quantity.
- Identify the equilibrium price and quantity when the additional external costs are considered.
For example, in a situation where a firm is playing trumpet songs and causing an increase in noise pollution, the negative externality would be the noise pollution. Taking the externality into account may lead to a shift in the supply curve and an increase in production costs. The equilibrium price and quantity can be determined by comparing the quantity demanded and the quantity supplied after paying the costs of the externality.