Applied Welfare Economics Lecture 3

1
Applied Welfare EconomicsLecture 3

• Hamish Low

2
Summary

• Diamond-Mirrlees Production efficiency should be
  maintained even if inefficiencies in consumption
• Result arises from the independence of the
  consumer side of the economy from the producer
  side (due to full set of taxes)

3
Outline Externalities

• Correcting Externalities to achieve the
  First-Best
• Coase theorem
• Pigouvian taxes
• Correcting Externalities in the Second-Best
• Common Property Resources
• local commons

4
Externalities
5
Coase

• First best, decentralised solution to the
  externality
• Allocate property rights
• Creates a market and the market determines the
  price of the externality

SMC
MB
Noise
6
Problems with Coase

• Transactions costs
• Thinness of markets
• Why did the externality arise in the first place?
• Leads to second best problem
• transactions costs are the underlying reason for
  the externality
• optimise taking account of this constraint

7
Pigouvian Taxes

• First best, centralised solution to the
  externality
• Pay tax equal to the marginal cost imposed on
  others
• Government determines the size of the tax to pay

SMC
MB
Noise
8
Problems with Pigou

• Informational requirements
• not in the firms interests to reveal information
  on marginal benefit of pollution
• government has to know marginal cost and benefit
  curves
• What if other distortions in place, so 2nd Best?
• eg need to use distortionary commodity taxes as
  in Diamond-Mirrlees?
• distinguish consumption from production
  externality

9
Social Optimum
Production imposes an externality on consumers.
Single consumer, single producer, two
goods Assume externality is the output of the firm
subject to
MRT
MRS
10
Competitive Equilibrium
Consumer
Producer
MRT
Private MRS
Too much of good 1 is converted into good 2
11
Pigouvian Tax
Consumer
Producer
FIRST BEST
But generates revenue
12
Budget Balance and the Second Best
Generates revenue
Budget Balance
Then consumers problem becomes
Pigouvian tax is no longer optimal. Greater
revenue raised implies a greater distortion to
the consumption allocation
13
Second Best (consumption externality)

• Pigouvian tax may interact with distortionary
  taxation and this becomes a second-best problem
• With irremovable distortion (no LST), theory of
  second best says satisfying other Pareto
  conditions may not be optimal so, should not use
  Pigouvian tax
• Sandmo (Swedish J of Econ, 1975) shows
• Pigouvian tax should not affect taxes imposed on
  other commodities
• Weight on Pigouvian tax depends on importance of
  revenue requirement (if revenue more important,
  then set taxes to optimise revenue collection not
  to correct externality)
• Principle of targetting (solve distortion where
  it arises)

14
Second Best(production externality)

• Cremer and Gahvari (J Pub Econ, 2001)
• Diamond-Mirrlees presumption of production
  efficiency
• so correct externality to move onto the
  production frontier using Pigouvian tax

15
Externalities in the Second Best

• Suppose externality, z, is not firm output but
  one of the inputs into firm production (eg noise)
• Suppose that monitoring externality is very
  costly (irremovable distortion that tax cannot be
  charged on noise directly).
• Second Best
• tax consumption of the final good (or tax on
  output)
• reduces demand for good and so reduces noise
  production
• D-M have we distorted production efficiency?
• maybe satisfy constrained production efficiency

16
Common Property Resources

• Local Commons production by one person uses up
  the resource for another
• Informal mechanisms. Repeated interaction may
  lead to cooperation if expected future gain is
  large enough
• discount rate low
• monitoring of each others behaviour feasible
  (small groups)
• credible punishment strategies
• What are the outside options for the defector?
• changing outside options changes possibilities
  for cooperation (eg better government provided
  insurance means being excluded from a community
  resource is less serious)

17
Common Property Resources

• Allocation of property rights privatisation
• Informal cooperation may be undermined
• changes the bargaining power between players in
  trying to cooperate
• may violate implicit entitlements
• not all actions are contractable cooperation
  over non-contractable actions may be undermined.
• Outside options undermine cooperation threat of
  retaliation by the User (player 2) is not enough
  to induce cooperation
• Failure of Coase remaining distortions
  (incomplete contracting) mean trying to reach
  first best makes individuals worse off

18
Conclusions

• Coase decentralised solution to problem of
  externalities (market determines price).
• Pigouvian taxes centralised solution (govt
  determines tax rate)
• Both restore economy to First Best
• But
• What if additional irremovable distortion (no
  lump sum taxes) modify Pigou or still satisfy
  D-M?
• Why has the externality arisen may be not
  possible to measure externality
• Common property resources providing property
  rights may not be second best optimal policy