If private responses to externalities don’t work or
don’t occur, there are a variety of ways the
government can intervene, including:
1)
2)
3)
4)
Taxes
Subsidies
Creating a Market (emission standards)
Regulation
1
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:
2
$
MSC
MPC+Tax
MPC
MEC
Tax
Tax
Revenue
Tax
MB
Movie Downloads
Q*
A per-unit tax shifts up the MPC curve by the amount of the
tax.
3
1)
2)
3)
4)
5)
Calculate optimal Q*
Calculate MPC(Q*)
Calculate MSC(Q*)
Tax= MSC(Q*)- MPC(Q*)
Conclude
OR
1) Calculate optimal Q*
2) Tax=MEC(Q*)
3) Conclude
4
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:
MB  40  2Q
MPC  2Q
MEC  Q
5
MB  40  2Q
MPC  2Q
MEC  Q
1)Public Q *
MB  MPC  MEC
Private :
40  2Q  2Q  Q
MB  MPC
8hours  Q *
40  2Q  2Q
10hours  Q
6
2)MPC(Q*)
MPC(Q*)  2Q *
MPC(8)  2(8)  16
3)MSC(Q*)
MPC(Q*)  3Q *
MPC(8)  3(8)  24
7
4)Tax  MSC(Q*) - MPC(Q*)
Tax  24 - 16
Tax  8
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).
8
MB  MPC  T
40  2Q  2Q  8
32  4Q
8Q
9
$
MSC=3Q
MPC+Tax=2Q+8
MPC=2Q
Tax
24
16
MEC=Q
Tax
Revenue
Tax
8
MB=40-Q
Bar Hours
The tax moves the bar from the private to the social
optimum.
10
-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 tax
2) Efficiency – sometimes a similar tax is more
efficient (tax on cars vs. tax on kilometers), but
less transparent
11
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:
12
$
MSC
MPC+Subsidy
MPC
MEC
Subsidy Cost
Subsidy
MB
Movie Downloads
Q*
Choosing to produce increases the MPC by the amount of
the subsidy given up
13
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
14
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
15
$
Selling the licences or
distributing them for
free and allowing
trading causes the
same equilibrium
price.
P
D
Movie Downloads
Q* Download Licences
Bigger and less efficient firms will buy more permits, while
smaller and more efficient firms will buy less
16 or none.
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
17
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.
18
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:
19
$
MSC=MPC+MEC
MPC
MEC
MBA
B* A*
MBB
Movie Downloads
A1=B1
These two firms have different optimal production, therefore
cannot be given the same production20
goal.
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
21
When externalities are large, there is room for
government involvement
-Due to lack of information, correct involvement can
be difficult
-No policy is perfect
22
-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) Taxes
3) Subsidies
4) Regulation
23
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
24
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
25
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-incomes
ie: Is regulating a Kraft Dinner factory good if the
price of Kraft Dinner doubles?
26
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
27
An POSITIVE EXTERNALITY occurs when:
1) The activity of one agent directly BENEFITS another
agent
And
2) 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
28
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:
29
$
MC=Supply
MSB=MPB+MEB
MPB
Security
MEB
Q1
Q*
With a positive externality, an product is underconsumed.
30
Assume family flu shots are available at the
local medical center in a small town. Let:
MC=50+Q
MPB=350-Q
MEB=200-Q
Therefore:
MSB=MPB+MEB
MSB=350-Q+200-Q
MSB=550-2Q
31
MEB=200-Q
MPB=350-Q
Individual:
MPB=MC
350-Q=50+Q
300=2Q
150=Q1
P1=50+Q
P1=50+150
P1=200
MSB=550-2Q
MC=50+Q
Society:
MSB=MC
550-2Q=50+Q
500=3Q
167=Q*
P*=50+Q
P*=50+167
P*=217
32
$
MC=50+Q
217
200
MSB=550-2Q
MEB=200-Q
MPB=350-Q
Security
150 167
With a positive externality, an product is underconsumed.
33
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 measure
2) Funding the subsidy redistributes taxes from
taxpayers to the recipients
3) The benefits of the externality may be regressive,
(such as funding liposuction research benefiting
the rich over the poor)
34
$
SMB=PMB+EMB
MC
MC-Subsidy
Subsidy
PMB
EMB
Q1
Security
Q*
The subsidy is related to the external marginal benefit.
35
1)
2)
3)
4)
5)
Calculate optimal Q*
Calculate MC(Q*)
Calculate PMB(Q*)
Tax= MC(Q*)- PMB(Q*)
Conclude
OR
1) Calculate optimal Q*
2) Subsidy=MEB(Q*)
3) Conclude
36
MEB=200-Q
MSB=550-2Q
MPB=350-Q
MC=50+Q
1) Calculate Q*
MSB=MC
550-2Q=50+Q
500=3Q
167=Q*
2) Subsidy =MEB(Q*)
MEB(Q*) = 200-167
MEB(Q*) = 33
37
MEB=200-Q
MSB=550-2Q
MPB=350-Q
MC=50+Q
SUBSIDY=$33
New Equilibrium:
Society:
P1=50+Q-33
MPB=MC-Subsidy
P1=50+167-33
350-Q=50+Q-33
P1=184
333=2Q
167=Q1
A $33 subsidy causes the optimal number of family
flu vaccines (167) to be purchased at a lower
price ($184 per family).
38
$
SMB=PMB+EMB
MC
MC-33
250
200
187
Subsidy
PMB
EMB
Security
150 167
With a subsidy, equilibrium quantity is increased.
39
$
SMB=PMB+EMB
MC
Externality
Benefit
MC
Consumer
Surplus
Subsidy
Producer
Surplus
PMB
EMB
Security
150 167
Externality benefits exist regardless of Q
40
$
SMB=PMB+EMB
MC
MC
Consumer
Surplus
Subsidy
PMB
EMB
Security
150 167
Consumer Surplus Increases
41
$
SMB=PMB+EMB
MC
MC
Subsidy
Producer
Surplus
PMB
EMB
Security
150 167
Producer Surplus Increases
42
$
SMB=PMB+EMB
Externality
Benefit
MC
MC
Subsidy
PMB
EMB
Security
150 167
Externality Benefits Increase
43
$
SMB=PMB+EMB
MC
MC
Gov. Subsidy Cost
Subsidy
PMB
EMB
Security
150 167
The Subsidy Has a Large Cost
44
$
SMB=PMB+EMB
MC
MC
Subsidy
Gov. Subsidy Cos
PMB
EMB
Security
150 167
There is a net benefit
45
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)
46