Introduction to Government Finance Admin 340

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Section 4
Externalities
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The Nature of Externalities

• An Externality occurs when an activity of one
  entity affects the welfare of another entity in a
  way that is outside the market.
• They occur when production and/or consumption
  inflicts third party cost or benefits on others
  for which no appropriate compensation is paid.
  

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The Nature of Externalities

• Examples include
• An oil tanker that discharges pollution on a
  popular beachor
• Aircraft noises that reduces the value of a
  house.
• These are whats known as negative
  externalities.

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The Nature of Externalities

• Private Costs
• incurred by the producer or consumer
• faced directly by them
• these are the internal costs of
  production/consumption
• Social Costs
• Social Cost Private Cost Externality effects
• Negative externalities add to social costs
• Consumer / producer does not normally take the
  social costs into account when making decisions

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Negative Externalities

• Negative Externalities are typically known as
  third party costs.
• They are spill over effects that impose costs
  on third parties as an accident byproduct of a
  voluntary trade.

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External Costs of Production
?
Marginal Social Cost
Costs Benefits
Marginal Private Cost
Marginal Private Benefit
Quantity of output produced
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External Costs of Production
External Costs
Marginal Social Cost
Costs Benefits
Marginal Private Cost
Marginal Private Benefit
Qs
Qp
Output produced
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Positive Externalities

• Positive Externalities are consequences of
  economics decisions that are beneficial to those
  who are affected by them.
• third party benefits!
• These are benefits which flow from an economic
  activity to someone not involved in the trade or
  transaction.

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Positive Externalities

• Where production and /or consumption leads to
  extra social benefits
• education training at all ages
• high quality health care
• employment creation by new small firms
• neigbourhood watch schemes
• educational usage of the internet
• flood protection systems
• arts and sporting participation
• Social marginal benefit gt private marginal benefit

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The Nature of Externalities

• Social Cost Private Cost External Cost
• Social Benefit Private Benefit External
  Benefit
• Private individuals and firms normally only
  consider the private costs benefits of an
  economic decision
• Social welfare maximized when
• social marginal cost social marginal benefit

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Graphical Analysis

• Fishing Example (Negative Externalities)
• Commuter Example (Positive Externalities).

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Private Responses to Externalities

• In the presence of externalities, an inefficient
  allocation of resources can emerge if no action
  is taken to correct it.

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Bargaining the Coase Theorem

• Economists argue that the root cause of the
  inefficiencies associated with externalities is
  the absence of property rights.
• It is believed therefore, that if property rights
  are assigned, individuals may respond to
  externalities by Bargaining with each other!

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Bargaining the Coase Theorem

• Consider the
• following example!

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The Coase Theorem

• Coase Theory implies that once property rights
  are established, no government intervention is
  required to deal with externalities.
• This theory is most relevant for cases in which
  only a few parties are involved and the sources
  of the externality are well defined.

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The Coase Theorem

• Therefore, if property rights are clearly
  defined, and if transaction costs are negligible,
  then
• The allocation of resources will be Pareto
  efficient and
• The allocation of resources does not depend on
  who holds the property rights.

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Public Responses to Externalities

• In some instances, private individuals and firms
  will not be able to attain an efficient solution,
  allowing for or requiring some type of government
  intervention.
• The more common options for government include
• Taxation
• Subsidization
• Market Creation and
• Regulation.

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Public Responses to Externalities - Taxes

• Levying a tax on the externality was proposed by
  A.C. Pigou to compensate for the fact that some
  of the inputs were priced too low.
• For example, a Pigouvian Tax is a tax levied on
  each unit of a polluters output in an amount
  just equal to the marginal damage it inflicts at
  the efficient level of output.

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Taxation of Negative Externalities

• Designed to make the polluter pay for some of
  the external costs they cause.
• Taxes will increase the costs of production
  i.e. they internalise the externalities.

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Taxation of Negative Externalities

• This should cause the producer / consumer to
  reduce their output / consumption.
• Lower output should reduce the pollution.

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Pollution Taxes?
MSC
Costs Benefits
MPC tax
MPC
MPB
Qs
Qp
Output produced
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Public Responses to Externalities - Taxes

• What are some practical challenges in
  implementing a Pigouvian Tax?

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Public Responses to Externalities - Subsidies

• A Subsidy for not creating a negative externality
  (i.e. polluting) is another method of raising the
  firms (polluters) effective production cost.
• The difference between the tax and subsidy
  schemes is that instead of having to pay, the
  individual or firm receives payment equal to the
  number of units of forgone production.

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Public Responses to Externalities - Subsidies

• What are some examples of how a subsidy might
  work?
• What are the three common problems with subsidy
  programs?

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Public Responses to Externalities Market
Creation

• The inefficiencies associated with externalities
  can also be linked to the absence of a market for
  the relevant resource.

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Public Responses to Externalities Market
Creation

• An effluent fee is charged by government to
  firms or individuals, thus creating a market.
• Examples include markets created for clean air or
  water.

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Public Responses to Externalities Market
Creation

• What are some examples?

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Public Responses to Externalities Regulation

• A Regulatory instrument would instruct an
  individual or firm to reduce the negative
  externality they produce (i.e. reduce pollution)
  or face legal sanctions.
• This approach is more of an enforcement style
  as opposed to an economic incentive method.

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Group Exercise!
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Any Questions?