Pigouvian tax and Coase theorem

1
Pigouvian tax and Coase theorem
Csaba Fogarassy
Erasmus Course, 2008 Szent Istvan University
Gödöllo
2
Externalities

• Governments can sometimes improve market
  outcomes!?
• Why do markets fail to allocate resources
  efficiently?
• How can government policies improve markets
  allocation?

3
Market failures

• Market failure occurs as a result of
• Market power
• Externalities
• Externality is the uncompensated impact of one
  persons action on the well-being of a bystander
• Adverse impact on the bystander is called a
  negative externality
• Beneficial impact on the bystander is called a
  positive externality

4
Externalities and Market Inefficiency

• Externalities cause markets to be inefficient,
  and thus fail.
• Demand curve reflects the value to the buyers and
  supply curve reflects the cost to the seller
• At market equilibrium, total surplus is maximized
• In the absence of externalities, market
  equilibrium is efficient
• Both decision-makers fail to take account of the
  external effects of their behavior

5
Negative Externalities in Production

• Negative externalities in production or
  consumption sometimes lead markets to produce a
  larger quantity than is socially desirable.
• The Social Costs of production or consumption are
  greater than the private cost or private benefit
  by producers and consumers.
• This leads to market failure.

6
Negative Externalities in Production

• Due to the negative externality, social cost is
  greater than private cost
• Social cost is the cost to the society of
  producing a product with a negative externality
• The difference between social cost and private
  cost is the cost of the negative externality
• The intersection between the demand curve and the
  social cost curve gives the optimum level of
  production

7
Private cost and marginal cost
8
Negative Externalities in Production

• In the presence of a negative externality
• Social costgt private cost
• Optimum quantity lt market equilibrium quantity
• The reduction in production raises economic
  well-being
• Economic well-being can be measured using the
  concept of deadweight loss
• Deadweight loss is the fall in total surplus that
  results from a market distortion, such as tax or
  tariff.

9
Economic welfare

• At market equilibrium, welfare is equal to the
  total surplus
• Producer surplus is measured as amount received
  by the sellers- social cost to the society
• At optimal quantity of production, consumer
  surplus is reduced but producer surplus increases
• The dead weight loss of producing at market
  equilibrium level rather than at optimal level is
  equal to the area of the triangle formed by the
  social-cost curve and demand curve

10
Economic welfare

• The dead weight loss is associated with the
  negative production externality
• Pigovian taxes
• The government can internalize the externality by
  imposing a tax on the producer. The tax shifts
  private cost supply up to social cost supply and
  eliminates the deadweight loss.
• Internalize an externality means to alter
  incentives so that people take account of the
  external effects of their actions
• Pigovian taxes are enacted to correct the effects
  of the negative externalities

11
Pigovian tax mechanism
12
Positive Externalities in Production

• Social cost of production Private cost -
  technology spillover
• The optimal quantity is larger than the
  equilibrium market quantity
• The positive externality can be internalized by
  imposing a Pigovian subsidy
• Patents are an example of internalizing positive
  externalities

13
Externalities in Consumption

• The analysis of consumption externalities is
  similar to that of production externalities
• The demand curve does not reflect the value of
  the good from societys point of view
• Negative consumption externality (tax)
• Positive consumption externality (subsidy)

14
Externalities Conclusion

• Negative externalities in production or
  consumption lead markets to produce a larger
  quantity than is socially desirable.
• Positive externalities in production or
  consumption lead markets to produce a smaller
  quantity than is socially desirable.
• Government can internalize externalities by
• Levying a tax on goods with negative
  externalities
• Imposing a subsidy on goods with positive
  externalities

15
Private or market solutions to Externalities

• Is it possible for private actors to allocate
  resources at the social optimum level?
• Types of private solutions
• Moral codes and social sanctions
• Charities
• Self-interest of involved/relevant parties
• Integration of different types of business
• Contracts

16
Private Solutions to Externalities

• The Coase theorem proposes that if private
  parties can bargain without cost over the
  allocation of resources, they can solve the
  problems of externalities on their own.
• The Coase theorem says that whatever the initial
  distribution of rights, the interested parties
  can always reach a bargain in which everyone is
  better off and the outcome is efficient.

17
Polluted pays instead of polluter pays principle
(PPP)
Figure about the Law of diminishing returns
18
Problems with the private solutions

• Why private solutions do not always work?
• Transaction costs are costs that parties incur
  in the process of agreeing and following through
  on a bargain
• Coordination costs increase as the number of
  interested parties increase
• Government is an institution designed for
  collective actions

19
Public Policies Toward Externalities

• Regulation- dictating maximum level/ adopting a
  particular technology
• Pigovian taxes and subsidies are more efficient
  than regulation as they achieve the same result
  by conferring a lower cost on the society
• Tradable pollution permits- limits the supply of
  pollution permits and the demand curve sets the
  price for pollution
• Pigovian Tax- sets a price on pollution and the
  demand curve determines the quantity of pollution

20
Economic vs. pollution

• There is some debate about whether to quantify
  externalities if the methods are imperfect. The
  usual response is that as long as we are honest
  about the flaws in the numbers, it is better to
  have some numbers than none
• (Carl V. Phillips, 1999).

21
Thanks for your attention!
Download from www.fogarassy.hu!
22
Appendix Deadweight loss

• Deadweight loss is the inefficiency caused by,
  for example, a tax or monopoly pricing.  The
  diagram below shows a deadweight loss (labeled
  "gone") caused by a sales tax.  By causing a
  difference between the pre-tax price received by
  producers and the after-tax price paid by
  consumers, the government secures the area
  labeled Government Revenue.  This revenue comes
  at the expense of the consumer surplus and
  producer surplus that would have existed in the
  no tax equilibrium.  The "gone" triangle of
  deadweight loss goes to no one because those
  transactions are prevented by the sales tax
  (Source http//www.econmodel.com/classic/terms/de
  adweight_loss.htm).

23
The Deadweight loss is triange on the figure with
gone title.
Source http//www.econmodel.com/classic/terms/dea
dweight_loss.htm