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8/3/2019 Pub Econ Lecture 05 Externalities
http://slidepdf.com/reader/full/pub-econ-lecture-05-externalities 1/33
Public FinanceDr. Katie Sauer
Externalities
8/3/2019 Pub Econ Lecture 05 Externalities
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I . Negative ExternalitiesA. Negative Production Externality
Ex: pollution from the production of steel- the steel plant incurs production costs andreceives payment for the steel it sells
- pollution from the plant harms fishermen
The social marginal cost of steel is greater than the
private marginal cost of steel.
SMC = PMC + Marginal Damage
8/3/2019 Pub Econ Lecture 05 Externalities
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Price
Quantity of Steel
PMC = S
PMB = D= SMB
Qm
Pm
The market outcomewill be where supplyand demand are equal.
The market ignoresexternalities.
The PMC + MD is thetrue cost to society of the action (SMC).
The socially optimaloutcome is a lower quantity.
SMC
Marginal Damage
Qso
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Price
Quantity of Steel
PMC = S
PMB = D= SMB
Qm
Pm
The market outcome isinefficient and results indeadweight loss due to
over production.
A corrective tax equal tothe MD would shift thePMC left to coincidewith the SMC.
SMC
Marginal Damage
Qso
8/3/2019 Pub Econ Lecture 05 Externalities
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B. Negative Consumption Externality
Ex: cigarette smoke- the individual who smokes incurs the costs and
benefits of smoking
- second-hand smoke bothers others- reduces their utility
The social marginal benefit of smoking is less than the private marginal benefit of smoking.
SMB = PMB - Marginal Damage
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Price
Quantity
PMC = S= SMC
PMB = D
Qm
Pm
The market outcome will be where supply anddemand are equal.
The market ignoresexternalities.
The PMC - MD is thetrue benefit to society of the action (SMB).
The socially optimaloutcome is a lower quantity.
SMB = PMB - MD
Marginal Damage
Qso
8/3/2019 Pub Econ Lecture 05 Externalities
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Price
Quantity
PMC = S= SMC
PMB = D
Qm
Pm
SMB = PMB - MD
Marginal Damage
Qso
The market outcome isinefficient and results indeadweight loss due toover consumption.
A corrective tax on
consumers equal to MDwould internalize theexternality.
8/3/2019 Pub Econ Lecture 05 Externalities
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II . Positive ExternalitiesA. Positive Production Externality
Ex: one firm¶s oil exploration- the firm incurs costs while exploring and alsoreceives benefits from new discoveries
- discovery of new oil reserves offers profitableopportunities for other firms
The social marginal benefit of oil exploration is greater than the private marginal benefit of oil exploration.
SMC = PMC - Marginal Benefit
8/3/2019 Pub Econ Lecture 05 Externalities
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Price
Quantity of Steel
PMC = S
PMB = D= SMB
Qm
Pm
The market outcome
will be where supplyand demand are equal.
The market ignoresexternalities.
The PMC - MB is thetrue cost to society of the action (SMC).
The socially optimaloutcome is a higher quantity.
SMC =PMC -MB
Marginal Benefit
Qso
8/3/2019 Pub Econ Lecture 05 Externalities
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Price
Quantity of Steel
PMC = S
PMB = D= SMB
Qm
Pm
SMC =PMC -MB
Marginal Benefit
Qso
The market outcome isinefficient and results indeadweight loss due tounder production.
A subsidy equal to MBwould shift the PMCcurve to the right to
coincide with the SMC.
8/3/2019 Pub Econ Lecture 05 Externalities
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B. Positive Consumption Externality
Ex: getting a flu shot- the individual incurs the costs and benefits of getting a flu shot
- other people benefit from not getting the flufrom that individual
The social marginal benefit of flu shots is greater than the
private marginal benefit of flu shots.
SMB = PMB + Marginal Benefit
8/3/2019 Pub Econ Lecture 05 Externalities
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Price
Quantity
PMC = S= SMC
SMB =PMB + MB
Qso
The market outcome will be where supply and
demand are equal.
The market ignoresexternalities.
The PMB + MB is thetrue benefit to society of the action (SMB).
The socially optimaloutcome is a higher quantity.
PMB = D
Marginal Benefit
Qm
Pm
8/3/2019 Pub Econ Lecture 05 Externalities
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Price
Quantity
PMC = S= SMC
SMB =PMB + MB
Qso
PMB = D
Marginal Benefit
Qm
Pm
The market outcome isinefficient and results indeadweight loss due tounder consumption.
A subsidy to consumers
in the amount of MBwould internalize theexternality.
8/3/2019 Pub Econ Lecture 05 Externalities
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III . Quantity vs Price Approach to Externalities
Allow abatement technologies to vary.
Basic model: one firm is polluting
What is the optimal level of pollution?
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The MD is the additional damage averted by pollutionreduction.
- measures SMB of pollution reduction- flat for simplicity (could be negatively sloped to
show diminishing returns to abatement)
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The PMB (D) for pollution reduction is flat at zero.- firm gets no benefit from paying to reduce
pollution
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The PMC is the firm¶s private cost of reducing pollution.- slopes up due to diminishing returns
- first unit of pollution reduction is cheaper than last unit of pollution reduction
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The PMC = SMC.- there are no externalities from pollution reduction
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The market outcome:PMB = PMC
The optimal outcome:SMB = SMC
R* is optimal reduction.
P* is optimal level of pollution.
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H ow to get a firm to choose R*?
1. Regulate it
2. implement a tax equal to MD
PMB + MD = SMB
shifts the firm¶s PMB up to coincide with SMB
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Now suppose there are two plants, each doing half of the polluting.
400 tons of sludge totalMD = $100 per ton
Plant A is newer than Plant B.- MC of pollution reduction for A is less than thatfor B
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MC A + MC B = MC Total
The socially optimal level of pollution reduction is:MC T = MD at 200 units
MD = SMB$100
Cost of PollutionReduction MC B
MC A
4000
PollutionReduction
MC T
50 200
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Suppose the government wants to reduce pollution by 200units.
- it could require each firm to reduce its pollution by 100 units
MD = SMB$100
Cost of PollutionReduction MC B
MC A
4000
PollutionReduction
MC T
50 200100
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The cost of that reduction is very costly for Plant B and notas costly for Plant A.
MD = SMB$100
Cost of PollutionReduction MC B
MC A
4000
PollutionReduction
MC T
50 200100
PB
PA
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A more efficient outcome is to have each plant reduce pollution to the point where MC = MD.
- reduce by 50 for Plant B- reduce by 150 for Plant A
MD = SMB$100
Cost of PollutionReduction MC B
MC A
4000
PollutionReduction
MC T
50 150 200100
PB
PA
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I n reality this is hard « the government would needto know each firm¶s individual MC of pollution
reduction.
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I nstead of mandating a particular quantity, the governmentcould achieve the same results by imposing a tax equal toMD.
PMB = MC for each firm
MD = SMB$100
Cost of PollutionReduction MC B
MC A
4000
PollutionReduction
MC T
50 150 200100
=PMB B = PMB A
PB
PA
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Another option for quantity regulation is to give each firm100 permits allowing each firm to pollute 100 units.
Firms could buy/sell permits among themselves.
MD = SMB$100
Cost of PollutionReduction MC B
MC A
4000
PollutionReduction
MC T
50 150 200100
PB
PA
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Firm B would be willing to pay up to P B for permit thatallows it to pollute one more unit (reduce pollution to 99).
Firm A would be willing to accept a minimum of P A
for selling a permit (reduce pollution to 101).
MD = SMB$100
Cost of PollutionReduction MC B
MC A
4000
PollutionReduction
MC T
50 150 200100
PB
PA
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IV . Uncertainty
Cost of pollutionreduction could be MC1or MC2.
A. Global Warming
- exact amount of
pollution reduction isn¶tcritical « cumulativeeffect from decades
- Flatish MD
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DWL from taxing is lessthan DWL fromregulating reduction.
B. Nuclear Leakage
- very small difference innuclear leakage can makea huge difference
- very steep MD(vertical?)
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DWL from taxing is morethan DWL from
regulating reduction.