Public Responses to Externalities

1
Public Responses to Externalities

• If private responses to externalities dont work
  or dont occur, there are a variety of ways the
  government can intervene, including
• Taxes
• Subsidies
• Creating a Market (emission standards)
• Regulation

2
1) Public Response Taxes

• Since actions with externalities have SMCgtPMC,
  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

3
Pigouvian Tax


MSC
MPCTax
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.
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Calculating an optimal Pigouvian Tax

1. Calculate optimal Q
2. Calculate MPC(Q)
3. Calculate MSC(Q)
4. Tax MSC(Q)- MPC(Q)
5. Conclude

OR

1. Calculate optimal Q
2. TaxMEC(Q)
3. Conclude

5
Numerical Example

• 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

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Numerical Example
7
Numerical Example
8
Numerical Example

• 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).

9
Check
10
Pigouvian Tax

MPCTax2Q8

MSC3Q
MPC2Q
Tax
24
MECQ
Tax Revenue
16
Tax
MB40-Q
Bar Hours
8
The tax moves the bar from the private to the
social optimum.
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1) Public Response Taxes

• -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
• Estimation one needs to know the exact MEC and
  MPC in order to calculate the tax
• Efficiency sometimes a similar tax is more
  efficient (tax on cars vs. tax on kilometers),
  but less transparent

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2) Public Response Subsidies

• Since actions with externalities have MSCgtMPC,
  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

13
Pigouvian Subsidy


MSC
MPCSubsidy
MPC
MEC
Subsidy Cost
Subsidy
MB
Movie Downloads
Q
Choosing to produce increases the MPC by the
amount of the subsidy given up
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2) Public Response Subsidies

• In addition to the the Pigouvian Tax issues, the
  Pigouvian Subsidy has 3 additional problems
• The subsidy raises profits, encouraging other
  firms to join the market and produce
  externalities
• 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

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3) Public Response Creating a Market

• 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

16
Externality Rights Market


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 or none.
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3) Public Response Creating a Market

• 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
• Permits directly chose the amount of pollution,
  instead of indirectly (and possibly incorrectly)
  determining it with taxes
• Permit prices automatically move with inflation,
  whereas a tax needs to be constantly re-assessed

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Creating a MarketCreating Market Power?

• 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.

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4) Public Response Regulation

• 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

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Regulation Difficulties


MSCMPCMEC
MPC
MEC
MBB
MBA
Movie Downloads
A1B1
A
B
These two firms have different optimal
production, therefore cannot be given the same
production goal.
21
Public Response Issues

• 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

22
Public Response Conclusion

• When externalities are large, there is room for
  government involvement
• -Due to lack of information, correct involvement
  can be difficult
• -No policy is perfect

23
Public Response Issues

• -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
• Creating a Market (Permits)
• Taxes
• Subsidies
• Regulation

24
Theory - Income Distribution Effects

• 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
• Who benefits?
• Who bears the cost

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1) Who Benefits?

• 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

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2) Who Bears the Cost?

• For negative externalities, the optimal output is
  LOWER
• Lower output gt 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?

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2) Who Bears the Cost?

• 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

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Theory - Positive Externalities

• 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

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Theory - Positive Externalities

• 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

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Positive Externality


MCSupply
MSBMPBMEB
MPB
MEB
Security
Q
Q1
With a positive externality, an product is
underconsumed.
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Graphical Example

• Assume family flu shots are available at the
  local medical center in a small town. Let
• MC50Q
• MPB350-Q
• MEB200-Q
• Therefore
• MSBMPBMEB
• MSB350-Q200-Q
• MSB550-2Q

32
Graphical Example

• MEB200-Q MSB550-2Q
• MPB350-Q MC50Q
• Individual
• MPBMC
• 350-Q50Q
• 3002Q
• 150Q1
• P150Q
• P150150
• P1200

Society MSBMC 550-2Q50Q 5003Q 167Q P50Q
P50167 P217
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Positive Externality


MC50Q
217
200
MSB550-2Q
MEB200-Q
MPB350-Q
Security
167
150
With a positive externality, an product is
underconsumed.
34
Positive Externalities

• This positive externality activity can be made
  efficient by using a Pigouvian subsidy
• This has three issues
• The amount of the subsidy is difficult to measure
• Funding the subsidy redistributes taxes from
  taxpayers to the recipients
• The benefits of the externality may be
  regressive, (such as funding liposuction research
  benefiting the rich over the poor)

35
Positive Externality


SMBPMBEMB
MC
MC-Subsidy
Subsidy
PMB
EMB
Security
Q
Q1
The subsidy is related to the external marginal
benefit.
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Calculating an optimal Pigouvian Subsidy

1. Calculate optimal Q
2. Calculate MC(Q)
3. Calculate PMB(Q)
4. Tax MC(Q)- PMB(Q)
5. Conclude

OR

1. Calculate optimal Q
2. SubsidyMEB(Q)
3. Conclude

37
Graphical Example

• MEB200-Q MSB550-2Q
• MPB350-Q MC50Q
• 1) Calculate Q
• MSBMC
• 550-2Q50Q
• 5003Q
• 167Q
• 2) Subsidy MEB(Q)
• MEB(Q) 200-167
• MEB(Q) 33

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Check

• MEB200-Q MSB550-2Q
• MPB350-Q MC50Q SUBSIDY33
• New Equilibrium
• MPBMC-Subsidy
• 350-Q50Q-33
• 3332Q
• 167Q1

Society P150Q-33 P150167-33 P1184
A 33 subsidy causes the optimal number of family
flu vaccines (167) to be purchased at a lower
price (184 per family).
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Positive Externality


SMBPMBEMB
MC
MC-33
250
200
Subsidy
187
PMB
EMB
Security
167
150
With a subsidy, equilibrium quantity is increased.
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Original Surplus and Benefits


SMBPMBEMB
MC
Externality Benefit
MC
Consumer Surplus
Subsidy
Producer Surplus
PMB
EMB
Security
167
150
Externality benefits exist regardless of Q
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Consumer Surplus with Subsidy


SMBPMBEMB
MC
MC
Consumer Surplus
Subsidy
PMB
EMB
Security
167
150
Consumer Surplus Increases
42
Producer Surplus with Subsidy


SMBPMBEMB
MC
MC
Subsidy
Producer Surplus
PMB
EMB
Security
167
150
Producer Surplus Increases
43
Externality Benefit with Subsidy


SMBPMBEMB
MC
Externality Benefit
MC
Subsidy
PMB
EMB
Security
167
150
Externality Benefits Increase
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Cost of Subsidy


SMBPMBEMB
MC
MC
Gov. Subsidy Cost
Subsidy
PMB
EMB
Security
167
150
The Subsidy Has a Large Cost
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Net Subsidy Benefit


SMBPMBEMB
MC
MC
Gov. Subsidy Cost
Subsidy
PMB
EMB
Security
167
150
There is a net benefit
46
Positive Externalities

• 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 arent, so please petition your government
  for Econ prof subsidies)