Overview
Overview
BA 210 Lesson III.4 Externalities
1
Lesson Overview
Chapter 17 Externalities
Optimal Taxes on Consumption
Optimal Taxes on Production
Optimal Subsidies on Consumption
Optimal Subsidies on Production
Controversy: The Value of Human Life
Summary
Review Questions
BA 210 Lesson III.4 Externalities
2
Optimal Taxes on Consumption
Optimal Taxes on Consumption
BA 210 Lesson III.4 Externalities
3
Optimal Taxes on Consumption
Introductory Example to Optimal Taxes
Suppose cigarettes cost $1.00 to produce each pack, and there are
enough competing producers that the no-tax market price equals
unit cost, $1.00. Suppose my benefits from smoking are: first
pack, $2.30; second, $1.60; third, $1.10; fourth, $0.60; and so on.
Suppose your loses from my smoking are $0.40 per pack.
Question 1: How many packs do I smoke in the competitiveequilibrium? Is that consumption efficient? (Hint: On the 3rd
pack, I gain $0.10 consumer surplus, but you loose $0.40)
Question 2: Name a tax on cigarettes that’s so high that the tax
equilibrium is inefficient. (Hint: Without tax, on the 1st pack, I
gain $1.30 surplus and you loose $0.40.)
Question 3: Name a tax on a pack of cigarettes that makes the
tax equilibrium efficient. (Hint: Compute efficient # of packs?)
BA 210 Lesson III.4 Externalities
4
Optimal Taxes on Consumption
The Demand and Supply for Cigarettes
The height of the demand curve is the marginal benefit from the
last pack of cigarettes. It is the value of cigarettes to the last
consumer. For example, the marginal benefit of the 5,000th pack
is $10.
$14
Price of a
pack of
cigarettes
12
A
S
10
Equilibrium
price
E
8
6
D = MB
4
2
0
Equilibrium
quantity
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of cigarettes
5
Optimal Taxes on Consumption
The Demand and Supply for Cigarettes
The height of the supply curve is the marginal cost of the last
pack of cigarettes. It is the cost of producing to the last producer.
For example, the marginal cost of the 5,000th pack is $6.
$14
Price of a
pack of
cigarettes
12
S = MC
10
Equilibrium
price
E
8
6
D = MB
B
4
2
0
Equilibrium
quantity
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of cigarettes
6
Optimal Taxes on Consumption
A Negative Externality in Consumption can be analyzed by a
decrease in the marginal social benefit of consumption below the
marginal benefit to consumers. (If a smoker benefits $8.20 and
non-smokers lose $4.00, then society as a whole benefits $4.20)
$14
Price of a
pack of
cigarettes
12
MSB curve shifts downward by the
amount of the externality --- the
marginal external effect
S = MC
10
E
8
6
D = MB
4
2
0
MSB
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of cigarettes
7
Optimal Taxes on Consumption
Total surplus is maximal (optimal) when marginal social benefit
equals marginal cost. A Pigouvian tax on consumers lowers their
marginal benefit to equal MSB, and so equilibrium quantity is
optimal.
$14
Buyers’ price
of a pack of
cigarettes
12
A
S = MC
10
Pigouvian tax =
$4 per unit
8
6
D = MB
B
4
2
0
MSB
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of cigarettes
8
Optimal Taxes on Consumption
Optimal (Pigouvian) Taxes on Consumption equal the marginal
external effect of the last unit consumed. Without the tax,
equilibrium quantity is too high, and it is possible to make
everyone better off by reducing consumption.
BA 210 Lesson III.4 Externalities
9
Optimal Taxes on Production
Optimal Taxes on Production
BA 210 Lesson III.4 Externalities
10
Optimal Taxes on Production
 Pollution is a bad thing. Yet most pollution is a side effect of
activities that provide us with good things, such as steel.
 Pollution is a side effect of useful activities, so the optimal
quantity of pollution isn’t zero.
 Then, how much pollution should a society have? What are the
costs and benefits of pollution?
BA 210 Lesson III.4 Externalities
11
Optimal Taxes on Production
The Demand and Supply for Steel
The height of the demand curve is the marginal benefit from the
last ton of steel. It is the value of steel to the last consumer. For
example, the marginal benefit of the 5,000th ton is $100.
$140
Price of a ton
of steel
120
A
S
100
Equilibrium
price
E
80
60
D = MB
40
20
0
Equilibrium
quantity
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of steel
12
Optimal Taxes on Production
The Demand and Supply for Cigarettes
The height of the supply curve is the marginal cost of the last ton
of steel. It is the cost of producing to the last producer. For
example, the marginal cost of the 5,000th ton is $60.
$140
Price of a ton
of steel
120
S = MC
100
Equilibrium
price
E
80
60
D = MB
B
40
20
0
Equilibrium
quantity
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of steel
13
Optimal Taxes on Production
A Negative Externality in Production can be analyzed by an
increase in the marginal social cost of production above the
marginal cost to producers. (If producers’ costs are $82 and the
environmental costs are $40, then societies’ costs are $122.)
$140
Price of a ton
of steel
MSC
120
S = MC
100
MSC curve shifts upward by the
amount of the externality --- the
marginal external effect
E
80
60
D = MB
40
20
0
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of steel
14
Optimal Taxes on Production
Total surplus is maximal (optimal) when marginal benefit equals
marginal social cost. A Pigouvian tax on producers raises their
marginal cost to equal MSC, and so equilibrium quantity is
optimal.
$140
Price of a ton
of steel
MSC
120
A
S = MC
100
Pigouvian tax =
$40 per unit
80
60
D = MB
B
40
20
0
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of steel
15
Optimal Taxes on Production
Optimal (Pigouvian) Taxes on Production equal the marginal
external effect of the last unit produced. Without the tax,
equilibrium quantity is too high, and it is possible to make
everyone better off by reducing production.
BA 210 Lesson III.4 Externalities
16
Optimal Subsidies on Consumption
Optimal Subsidies on Consumption
BA 210 Lesson III.4 Externalities
17
Optimal Subsidies on Consumption
The Demand and Supply for Flu Shots
The height of the demand curve is the marginal benefit from the
last flu shot. It is the value of a flu shot to the last consumer. For
example, the marginal benefit of the 10,000th shot is $4.
$14
Price of a flu
shot
12
S
10
8
Equilibrium
price
6
E
A
4
2
0
Equilibrium
quantity
5,000
10,000
D = MB
15,000
BA 210 Lesson III.4 Externalities
Quantity of flu shots
18
Optimal Subsidies on Consumption
The Demand and Supply for Flu Shots
The height of the supply curve is the marginal cost of the last flu
shot. It is the cost of producing to the last producer. For
example, the marginal cost of the 10,000th shot is $8.
$14
Price of a flu
shot
12
S = MC
10
B
8
Equilibrium
price
6
E
4
2
0
Equilibrium
quantity
5,000
10,000
D = MB
15,000
BA 210 Lesson III.4 Externalities
Quantity of flu shots
19
Optimal Subsidies on Consumption
A Positive Externality in Consumption can be analyzed by an
increase in the marginal social benefit of consumption below the
marginal benefit to consumers. (If a patient benefits $4.20 and
others benefits $4.00, then society as a whole benefits $8.20)
$14
Price of a flu
shot
12
MSB curve shifts upward by the
amount of the externality --- the
marginal external effect
S = MC
10
8
6
MSB
E
4
2
0
D = MB
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of flu shots
20
Optimal Subsidies on Consumption
Total surplus is maximal (optimal) when marginal social benefit
equals marginal cost. A Pigouvian subsidy on consumers raises
their marginal benefit to equal MSB, and so equilibrium quantity
is optimal.
$14
Buyers’ price
of a flu shot
12
S = MC
10
B
8
Pigouvian subsidy
= $4 per unit
6
D = MB
A
4
2
0
MSB
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of flu shots
21
Optimal Subsidies on Consumption
Optimal (Pigouvian) Subsidies on Consumption equal the
marginal external effect of the last unit consumed. Without the
tax, equilibrium quantity is too low, and it is possible to make
everyone better off by increasing consumption.
BA 210 Lesson III.4 Externalities
22
Optimal Subsidies on Production
Optimal Subsidies on Production
BA 210 Lesson III.4 Externalities
23
Optimal Subsidies on Production
The Demand and Supply for Honey
The height of the demand curve is the marginal benefit from the
last case of honey. It is the value of honey to the last consumer.
For example, the marginal benefit of the 10,000th case is $80.
$140
Price of a case
of honey
Equilibrium
price
S
120
E
100
A
80
60
Equilibrium
quantity
D = MB
40
20
0
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of honey
24
Optimal Subsidies on Production
The Demand and Supply for Cigarettes
The height of the supply curve is the marginal cost of the last ton
of steel. It is the cost of producing to the last producer. For
example, the marginal cost of the 10,000th case is $120.
$140
Price of a case
of honey
Equilibrium
price
S = MC
B
120
E
100
80
60
Equilibrium
quantity
D = MB
40
20
0
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of honey
25
Optimal Subsidies on Production
A Positive Externality in Production can be analyzed by an
decrease in the marginal social cost of production below the
marginal cost to producers. (If producers’ costs are $122 and the
environmental benefits to plants are $40, then societies’ costs are
$82.)
$140
S = MC
Price of a case
of honey
120
E
MSC
100
MSC curve shifts downward by the
amount of the externality --- the
marginal external effect
80
60
D = MB
40
20
0
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of honey
26
Optimal Subsidies on Production
Total surplus is maximal (optimal) when marginal benefit equals
marginal social cost. A Pigouvian tax on producers lowers their
marginal cost to equal MSC, and so equilibrium quantity is
optimal.
$140
Price of a case
of honey
120
Pigouvian subsidy
= $40 per unit
100
S = MC
B
MSC
A
80
60
D = MB
40
20
0
5,000
10,000
15,000
BA 210 Lesson III.4 Externalities
Quantity of honey
27
Optimal Subsidies on Production
Optimal (Pigouvian) Subsidies on Production equal the marginal
external effect of the last unit produced. Without the subsidy,
equilibrium quantity is too lower, and it is possible to make
everyone better off by increasing production.
BA 210 Lesson III.4 Externalities
28
Controversy: Value of Human Life
Controversy: Value of Human Life
BA 210 Lesson III.4 Externalities
29
Controversy: Welfare
There are several practical problems to overcome when
measuring the harmful marginal external effect of negative
externalities like smoking cigarettes or producing pollution. If,
say, the last cigarette pack increased by 0.00001% the chance of
people near you dying of cancer, you must place a dollar value on
their lives to determine the optimal tax.
BA 210 Lesson III.4 Externalities
30
Controversy: Welfare
What is the dollar value of someone's life? Is it infinity? --- as
Catholics and lawyers tell us. Maybe they are right, but as
economists we work under the assumption of rationality.
Someone's life has the same value that they place on it.
BA 210 Lesson III.4 Externalities
31
Controversy: Welfare
For example, suppose that by inspecting your roof yourself,
rather than having someone else do it for you, you save $20, but
increase your chance of death (by falling) by 0.0001%. Consider
these implications:
Since rich people do not find $20 enough incentive to inspect
their own roofs, the value of their lives is more than $20.
Since poor people do find $20 enough incentive to inspect their
own roofs, the value of their lives is less than $20.
In particular, the cost of risking a rich person's life is greater than
the cost of risking a poor person's life.
BA 210 Lesson III.4 Externalities
32
Controversy: Welfare
The optimal tax on various negative externalities is affected by
the difference in cost of risking a rich person's life and risking a
poor person's life:
 Drunk and reckless driving and speeding should be more
heavily enforced and punished in rich neighborhoods.
 Dumping toxic waste should be more heavily restricted and
punished in rich neighborhoods.
BA 210 Lesson III.4 Externalities
33
Summary
Summary
BA 210 Lesson III.4 Externalities
34
Review Questions
Review Questions
 You should try to answer some of the following questions
before the next class.
 You will not turn in your answers, but students may request
to discuss their answers to begin the next class.
 Your upcoming cumulative Final Exam will contain some
similar questions, so you should eventually consider every
review question before taking your exam.
BA 210 Lesson III.4 Externalities
35
Review Questions
Follow the link
http://faculty.pepperdine.edu/jburke2/ba210/PowerP3/Set11Answers.pdf
for review questions for Lesson III.4
BA 210 Lesson III.4 Externalities
36
Review Questions
Review Question 1
BA 210 Lesson III.4 Externalities
37
Review Questions
Question 1. To understand how to promote social behavior,
consider the lifetime demand for flu shots by a typical (selfish)
person:
$ price per
shot
0.00
0.60
0.90
1.00
1.10
1.20
1.30
1.40
1.50
Shots
demanded
8
7
6
5
4
3
2
1
0
Suppose the marginal cost of producing flu shots is $1.20 per
shot. Suppose that each person has 2 co-workers, and each
benefits by $0.10 for each shot the person takes.
If the government imposes the optimal subsidy, how
many shots does each person take?
BA 210 Lesson III.4 Externalities
38
Review Questions
Answer 1. Since shots are an example of a positive consumption
externality, use this formula: (Optimal subsidy) = (marginal
external effect on everyone else). Hence, given the data,
(Efficient subsidy) = 2 × 0.10 = 0.20
Hence, the buyer’s price falls from 1.20 to 1.20−.20 = 1.00.
Conclusion: Reading from the demand curve, 5 shots are taken by
each person.
$ price per
shot
0.00
0.60
0.90
1.00
1.10
1.20
1.30
1.40
1.50
Shots
demanded
8
7
6
5
4
3
2
1
0
BA 210 Lesson III.4 Externalities
39
Review Questions
Review Question 2
BA 210 Lesson III.4 Externalities
40
Review Questions
Question 2. To understand how to control anti-social behavior,
consider a world with 6 people: 1 drinks and drives, 5 do not
drink. Here is the demand for shots of whisky by the drinker.
$ price per
shot
0.00
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Shots
demanded
7
6
5
4
3
2
1
0
Suppose each of the 5 drink-haters loses $0.05 of happiness for
each pint the drinker drinks. (The cost includes the chance of
being killed by the drunk driver.) Suppose the unit cost of
producing whisky is $0.40 per shot, and the market is perfectly
competitive.
BA 210 Lesson III.4 Externalities
41
Review Questions
$ price per
shot
0.00
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Shots
demanded
7
6
5
4
3
2
1
0
Assuming there are no taxes or subsidies, compute total surplus.
Assuming the government imposes the optimal tax, compute the
number of shots of whisky that are drunk.
Assuming the government imposes the optimal tax, then compute
total surplus.
BA 210 Lesson III.4 Externalities
42
Review Questions
Answer 2.
$ price per
shot
0.00
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Shots
demanded
7
6
5
4
3
2
1
0
Since the market is perfectly competitive, the sellers’ price of
whisky is $0.40 per shot.
Assuming there are no taxes or subsidies, consumption = 6,
producer surplus = 0, consumer surplus
= 1.00+0.90+0.80+0.60+0.30+0.00 minus 5x0.05x6 = $2.10,
So total surplus is $2.10
BA 210 Lesson III.4 Externalities
43
Review Questions
$ price per
shot
0.00
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Shots
demanded
7
6
5
4
3
2
1
0
Assuming the government imposes the optimal tax = marginal
external effect = 5x0.05 per shot, the buyers’ price of whisky is
0.40+0.25 = $0.65 per shot, so 5 shots of whisky are drunk.
Assuming the government imposes the optimal tax, consumption
= 5, producer surplus = 0, consumer surplus
= 0.75+0.65+0.55+0.35+0.05 = $2.35,
Since the tax revenue balances the external effect, the optimal tax
increased total surplus to $2.35
BA 210 Lesson III.4 Externalities
44
Review Questions
Review Question 3
BA 210 Lesson III.4 Externalities
45
Review Questions
Question 3. To understand how to control anti-social behavior,
consider a world with 9 people: 1 smokes, 3 do not care about
smoke, 5 hate the smell of smoke. Here is the demand for
cigarettes by the smoker.
$ price
per pack
0.00
0.20
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Packs
demanded
8
7
6
5
4
3
2
1
0
Suppose each of the 5 smoke-haters loses $0.10 of happiness for
each pack the smoker smokes.(The cost includes the chance of
dying from second-hand smoke.) Suppose the unit cost of
producing cigarettes is $0.20 per pack, and the market is perfectly
competitive.
BA 210 Lesson III.4 Externalities
46
Review Questions
$ price
per pack
0.00
0.20
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Packs
demanded
8
7
6
5
4
3
2
1
0
Assuming there are no taxes or subsidies, compute total surplus.
Assuming the government imposes the optimal tax, compute the
number of shots of whisky that are drunk.
Assuming the government imposes the optimal tax, then compute
total surplus.
BA 210 Lesson III.4 Externalities
47
Review Questions
Answer 2.
$ price
per pack
0.00
0.20
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Packs
demanded
8
7
6
5
4
3
2
1
0
Since the market is perfectly competitive, the sellers’ price of
cigarettes is $0.20 per pack.
Assuming there are no taxes or subsidies, consumption = 7,
producer surplus = 0, consumer surplus
= 1.20+1.10+1.00+0.80+0.50+0.20+0.00 - 5x0.10x7 = $1.30,
So total surplus is $1.30
BA 210 Lesson III.4 Externalities
48
Review Questions
$ price
per pack
0.00
0.20
0.40
0.70
1.00
1.20
1.30
1.40
1.50
Packs
demanded
8
7
6
5
4
3
2
1
0
Assuming the government imposes the optimal tax = marginal
external effect = 5x0.10 per pack, the buyers’ price of cigarettes
is 0.20+0.70 = $0.70 per pack, so 5 packs are smoked.
Assuming the government imposes the optimal tax, consumption
= 5, producer surplus = 0, consumer surplus
= 0.70+0.60+0.50+0.30+0.00 = $2.10,
Since the tax revenue balances the external effect, the optimal tax
increased total surplus to $2.10
BA 210 Lesson III.4 Externalities
49
BA 210
Introduction to Microeconomics
End of Lesson III.4
BA 210 Lesson III.4 Externalities
50