Copyright © 2002 by Thomson Learning, Inc. Chapter 3 Externalities and Public Policy Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark

Copyright © 2002 by Thomson Learning, Inc.

Chapter 3

Externalities and Public Policy

Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license.

ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom

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systems—without the written permission of the publisher. Printed in the United States of America

ISBN 0-03-033652-X


Externalities

Externalities are costs or benefits of market transactions not reflected in prices. Negative externalities are costs to third

parties. Positive externalities are benefits to third

parties .


Externalities and Efficiency

The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good. This occurs when there is a negative externality.


Social Costs

MSC = MPC + MEC


Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency

D = MSB

S = MPC

MPC + MEC = MSC

10

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Tons of Paper Per Year (Millions)

110

105

100

4.5 5

A

B

G

10


Implications of Figure 3.1

Market equilibrium occurs where

MPC = MSBEfficiency Requires that

MSC = MPC + MEC = MSB


Positive externalities

The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production of consumption of a good. This occurs when there is a positive externality.


Social Benefit

MSB = MPB + MEB


Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency

S = MSC

MPB + MEB = MSBH

Z

U

V

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Inoculations Per Year (Millions)

10

25

30

45

10 120


Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output

S' = MSC'

C

B F

A

S = MSC

MPBi

MPBi + MEB = MSB

Pri

ce

, B

en

efi

t, a

nd

Co

st

(Do

llars

)

Inoculations per Year (Millions)

0

30

25

20

10 12 16 20


Internalization of Externalities

An externality can be internalized if there is a policy that causes market participants to account for the costs of benefits of their actions.


Corrective Taxes to Negative Externalities

Setting a tax equal to the MEC will internalize a negative externality.


Figure 3.4 A Corrective TaxP

rice

, B

enef

it,

and

Co

st (

Do

llar

s)

Tons of Paper Per Year (Millions)

100

5

110

105

95

4.5

D = MSB

S = MPC

A

S’ = MPC + T = MSC

Tax Revenue = TotalExternal Costs

T

Net Gains in Well-Being

GB


Results of a Corrective Tax

Socially optimal levels of production are achieved.

The tax revenue is sufficient to pay costs to third parties.


Using a Corrective Tax

The greenhouse effect and a “Carbon Tax” If it is accepted that the greenhouse effect

is caused by burning carbon-based fuels, a carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels.

It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.


Theory of the Second Best

When one condition for an optimum is violated then maintaining the others will not guarantee a second-best solution.


A Polluting Monopolist

In Chapter 2 it was shown that monopoly created a loss to society. In this chapter it was shown that a negative externality causes a loss as well.

The losses do not necessarily add to one another. In fact, they can cancel each other out.


Figure 3.5 A Second Best Efficient Solution

D = MSB

MPC

MPC + MEC = MSC

MR

Pri

ce

Output per Year 0 Q M Q*

P M

A F

B

C


Corrective Subsidies

Setting a subsidy equal to MEB will internalize a positive externality


Subsidy Payments

Figure 3.6 A Corrective Subsidy

i

i

Y

D = MPB

D' = MPB + $20 = MSB

S = MSC

Pric

e, B

en

efit

, an

d C

ost

(D

olla

rs)

Inoculations per Year (Millions) 0

45

30

25

10

10 12

Z

V R

X

U


Coase's Theorem

By establishing rights to use resources government can internalize externalities when transactions or bargaining costs are zero.


Figure 3.7 Coase’s Theorem

B A

MCW MC* W

MPCB + MEC = MSC

MPCB

Pri

ce o

f B

eef

(Do

llar

s)

Pri

ce

of

Wh

eat

(D

olla

rs)

Wheat Output per Year

PW

Q* W QW1 Beef Output per Year

Q* B

QB1

PB


Limitations of Coase’s Theorem

Transactions costs are not zero in many situations.

However you allocate the property right, the distribution of income is affected.


Applying Coase's Theorem

The Clean Air Act of 1990 allows for the sale of the "right to pollute." Firms face a tradeoff when they pollute. If they pollute they forgo the right to sell the emission permit to others.

With electricity this has motivated firms to shift to natural gas and away from coal as a means of producing electricity.


Figure 3.8 Pollution Rights and Emissions

S = Supply of Pollution Rights

D = MSB of Emitting Wastes

Pri

ce

an

d M

arg

ina

l So

cia

l Be

ne

fit

Tons of Annual Emissions and Number of Pollution Rights

0

$20

75,000 100,000


Figure 3.9 The Efficient Amount of Pollution Abatement

E

MSB

MSC M

arg

ina

l So

cia

l Co

st

an

d B

en

efi

t

Percent Reduction in Wastes Emitted per Year 0 A* 100


Regulatory Solutions

Instead of using market forces to cause firms to internalize externalities we can use emission standards and apply these to all.


Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of

Emissions

A MEC = MSC

MSB

MEC = MSC

MSB

B

C

F

QRB

QRA

G

H

0 QR

10

Firm A

10 Co

st a

nd

Ben

efit

(D

oll

ars)

Firm B

Q* A

Q* B

QB1

QB1

Tons of Emissions per Year


Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions

MEC = MSC

MSB MEC = MSC

S

Y

Z T R

X

QRD

QRC

Firm C

Tons of Emissions per Year

Firm D

20

Q* C

QR

Q* D

QRC

ost

an

d B

enef

it (

Do

llar

s)


Sulfur Dioxide Emission Prices

SOURCE: United States Environmental Protection Agency

250

200

150

100

50

0 8/1/94

Allo

wa

nc

e P

ric

e (

Do

llars

)

Month/Year

8/1/95 8/1/95 8/1/958/1/95 8/1/95

Fieldston Publications Price Index Cantor Fitzgerald Market Price Index


Global Externalities

CFC’sDeforestationGlobal Warming

Documents

Copyright © 2002 by Thomson Learning, Inc. Chapter 3 Externalities and Public Policy Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark