1

If private responses to externalities don’t work or don’t occur, there are a variety of ways the government can intervene, including:

1) Taxes2) Subsidies3) Creating a Market (emission standards)4) Regulation

2

Since actions with externalities have SMC>PMC, one way to raise PMC is through taxation

-a PIGOUVIAN TAX is a per-unit tax on output equal to the marginal external cost at the efficient level of output, Q*

-If administrated correctly, the can move production to the efficient level of output:

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MEC

MSC

MB

MPC

Tax

A per-unit tax shifts up the MPC curve by the amount of the tax.

Q*

Tax

Tax Revenue

MPC+Tax

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1) Calculate optimal Q*2) Calculate MPC(Q*)3) Calculate MSC(Q*)4) Tax= MSC(Q*)- MPC(Q*)5) Conclude

1) Calculate optimal Q*2) Tax=MEC(Q*)3) Conclude

OR

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Consider a bar near a residential neighborhood on a Friday night. Every hour the bar is open past 5pm has a negative impact on the neighborhood (due to noise, etc). Calculate private production and an ideal tax based on the following:

QMEC

QMPC

QMB

2

240

6

QMEC

QMPC

QMB

2

240

Qhours

QQ

MPCMB

10

2240

:Private

*8

2240

*Q Public1)

Qhours

QQQ

MECMPCMB

7

16)8(2MPC(8)

*2MPC(Q*)

MPC(Q*)2)

Q

24)8(3MPC(8)

*3MPC(Q*)

MSC(Q*)3)

Q

8

8Tax

16-42Tax

MPC(Q*)-MSC(Q*)Tax4)

An hourly tax of $8 would cause the bar to be open until the social optimum of 1 am (8 hours) instead of the private optimum of 3 am (10 hours).

9

Q

Q

QQ

TMPCMB

8

432

82240

10

Bar Hours

$

MEC=Q

MSC=3Q

MB=40-Q

MPC=2Q

Tax

The tax moves the bar from the private to the social optimum.

8

Tax

Tax Revenue

MPC+Tax=2Q+8

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16

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-The Pigouvian tax also yields tax revenue-It may be tempting to give this tax revenue to the victims of the externality, but this distorts the market, and encourages others to experience the negative externality in order to get the payment

Pigouvian Taxes have 2 concerns:1) Estimation – one needs to know the exact MEC

and MPC in order to calculate the tax2) Efficiency – sometimes a similar tax is more

efficient (tax on cars vs. tax on kilometers), but less transparent

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Since actions with externalities have MSC>MPC, another way to raise PMC is through subsidy

-a PIGOUVIAN SUBSIDY is a per-unit subsidy on REDUCED output equal to the marginal damage at the efficient level of output, Q*

-Therefore choosing to produce has the added MPC of giving up the subsidy

-If administrated correctly, the can move production to the efficient level of output:

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MEC

MSC

MB

MPC

Choosing to produce increases the MPC by the amount of the subsidy given up

Q*

Subsidy

Subsidy Cost

MPC+Subsidy

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In addition to the the Pigouvian Tax issues, the Pigouvian Subsidy has 3 additional problems:

1) The subsidy raises profits, encouraging other firms to join the market and produce externalities

2) The financing of the subsidy cost often comes from additional distortionary taxation that further restricts the economy-The externality may be less costly

3) Paying a firm not to pollute is often unpopular

15

Another way for the government to control externalities (ie: pollution) is to sell a set supply of externality permits

-A competitive auction will automatically find an equilibrium price for these permits

-An EFFLUENT FEE is the price charged for the right to pollute

-Note that alternately, the government could freely distribute these permits. The equilibrium price would arise from trading among firms, only equity would be affected

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$ Selling the licences or distributing them for

free and allowing trading causes the same equilibrium

price.

Q* Download Licences

D

P

Bigger and less efficient firms will buy more permits, while smaller and more efficient firms will buy less or none.

17

Like Pigouvian taxes, we need information on optimal MEC, pollution and the relation between pollution and MEC to accurately issue permits.

Permits do, however, have advantages over Pigouvian taxes:

1) Permits directly chose the amount of pollution, instead of indirectly (and possibly incorrectly) determining it with taxes

2) Permit prices automatically move with inflation, whereas a tax needs to be constantly re-assessed

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In theory, one firm could over purchase permits in an attempt to keep other firms out of the market.

The feasibility of such a policy is difficult to predict.

If it did occur, new market power would harm efficiency.

19

The government can force a firm to produce at Q* or face legal sanctions.

Unfortunately, regulation is likely to be inefficient in a market with more than one firm.-Firms have different sizes and curves-Can one production level satisfy all firms?-Can one production reduction amount satisfy all firms?

-Examine the simple case where two firms (A and B) differ only in MB schedules:

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MEC

MSC=MPC+MEC

MBA

MPC

These two firms have different optimal production, therefore cannot be given the same production goal.

A1=B1

MBB

A*B*

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Externalities also differ across locations. A driver in the middle of the wilderness has less effect than an Edmontonian driver, who may have less effect than a driver in Toronto

-should Edmontonian drivers be punished according to Toronto standards?-Differing standards increases administration costs

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When externalities are large, there is room for government involvement

-Due to lack of information, correct involvement can be difficult-No policy is perfect

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-Typically, economic incentives (tax, subsidy, permits) to reduce pollution have the best impact, as they encourage greener practices

-Efficiency typically puts taxes and permits above subsidies and regulations

Preference order is often:1) Creating a Market (Permits)2) Taxes3) Subsidies4) Regulation

24

Although government is responsible to ensure efficiency in the case of externalities, it is also responsible to take into account the distribution effects of its policies

In short, when dealing with externalities the government has to ask:

1) Who benefits?2) Who bears the cost

25

If dealing with externalities favors the rich over the poor, the policy has distribution issues.

Examples:-If poorer areas are more polluted that rich areas,

reducing pollution (an externality) has a good distributional effect

-If richer people care more about the externality than poorer people (ie: litter in national parks, noise pollution), removing the externality has a bad distributional effect

26

For negative externalities, the optimal output is LOWER

Lower output => more unemployment and reduced wages, generally landing on low-income households

As seen in the previous graphs, forcing firms to realize MSC increases prices, which can be bad if the good is more used by lower-incomesie: Is regulating a Kraft Dinner factory good if the price of Kraft Dinner doubles?

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Some studies have shown pollution control to have bad distributional (regressive) effects:

-Hamilton and Cameron (1994) conclude that a carbon tax would reduce the lowest 20% of incomes by 3.4% and the highest 20% of incomes by only 2.7%

-Many energy taxes in US and Europe have regressive impacts

-One must also consider equity across locations -Toronto may favor an oil tax, but Edmonton would be more in favor of a big city tax

28

An POSITIVE EXTERNALITY occurs when:

1) The activity of one agent directly BENEFITS another agent

And2) This affect is not transmitted by market prices

Examples:-Getting the flu shot prevents others from getting sick-Writing your exam version on your exam speeds up

marking, so everyone gets their exams back faster

29

Although negative externalities are most often discussed, positive externalities can also lead to inefficiency

-When an economic activity has an Marginal External Benefit (MEB), it causes the Marginal Social Benefit (MSB) to be greater than the Marginal Private Benefit (MPB), causing underproduction:

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MEB

MC=Supply

With a positive externality, an product is underconsumed.

MPB

Q*Q1

MSB=MPB+MEB

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Assume family flu shots are available at the local medical center in a small town. Let:

MC=50+QMPB=350-QMEB=200-QTherefore:MSB=MPB+MEBMSB=350-Q+200-QMSB=550-2Q

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MEB=200-Q MSB=550-2QMPB=350-Q MC=50+QIndividual:MPB=MC350-Q=50+Q300=2Q150=Q1

P1=50+QP1=50+150P1=200

Society:MSB=MC550-2Q=50+Q500=3Q167=Q*P*=50+QP*=50+167P*=217

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MEB=200-Q

MC=50+Q

With a positive externality, an product is underconsumed.

MPB=350-Q

167150

MSB=550-2Q

217200

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This positive externality activity can be made efficient by using a Pigouvian subsidy:

This has three issues:1) The amount of the subsidy is difficult to measure2) Funding the subsidy redistributes taxes from

taxpayers to the recipients3) The benefits of the externality may be regressive,

(such as funding liposuction research benefiting the rich over the poor)

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EMB

MC

The subsidy is related to the external marginal benefit.

PMB

Q*Q1

SMB=PMB+EMB

Subsidy

MC-Subsidy

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1) Calculate optimal Q*2) Calculate MC(Q*)3) Calculate PMB(Q*)4) Tax= MC(Q*)- PMB(Q*)5) Conclude

1) Calculate optimal Q*2) Subsidy=MEB(Q*)3) Conclude

OR

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MEB=200-Q MSB=550-2QMPB=350-Q MC=50+Q1) Calculate Q*MSB=MC550-2Q=50+Q500=3Q167=Q*2) Subsidy =MEB(Q*)MEB(Q*) = 200-167MEB(Q*) = 33

38

MEB=200-Q MSB=550-2QMPB=350-Q MC=50+Q SUBSIDY=$33New Equilibrium:MPB=MC-Subsidy350-Q=50+Q-33333=2Q167=Q1

Society:P1=50+Q-33P1=50+167-33P1=184

A $33 subsidy causes the optimal number of family flu vaccines (167) to be purchased at a lower price ($184 per family).

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EMB

MC

With a subsidy, equilibrium quantity is increased.

PMB

167150

SMB=PMB+EMB

Subsidy

MC-33

250

187200

40

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$

EMB

MC

Externality benefits exist regardless of Q

PMB

167150

SMB=PMB+EMB

Subsidy

MCConsumer Surplus

ExternalityBenefit

ProducerSurplus

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$

EMB

MC

Consumer Surplus Increases

PMB

167150

SMB=PMB+EMB

Subsidy

MCConsumer Surplus

42

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$

EMB

MC

Producer Surplus Increases

PMB

167150

SMB=PMB+EMB

Subsidy

MC

ProducerSurplus

43

Security

$

EMB

MC

Externality Benefits Increase

PMB

167150

SMB=PMB+EMB

Subsidy

MC

ExternalityBenefit

44

Security

$

EMB

MC

The Subsidy Has a Large Cost

PMB

167150

SMB=PMB+EMB

Subsidy

MC

Gov. Subsidy Cost

45

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$

EMB

MC

There is a net benefit

PMB

167150

SMB=PMB+EMB

Subsidy

MC

Gov. Subsidy Cost

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Finally, note that just because an activity is beneficial does not mean it has a positive externality-Not all good activities need be subsidized

Examples:-Many great workers (surgeons, firemen, kind

insurance adjusters, emergency plumbers) are already compensated through a high wage (Econ profs aren’t, so please petition your government for Econ prof subsidies)