P Q CORRECTING SPILLOVER COSTS D 0 Spillover costs StSt S TAX Overallocation Corrected Q0Q0 QeQe

P Q CORRECTING SPILLOVER BENFITS 0 Q0Q0 QeQe D S DtDt Subsidy to consumer increases demand Underallocation Corrected Correcting by Subsidy to Consumers

P Q D 0 Subsidy to producers increases supply StSt S’ t Underallocation Corrected QeQe Q0Q0 Correcting by Subsidy to Producers CORRECTING SPILLOVER BENFITS

S = Supply of pollution rights D 2012 Price per pollution right Quantity of pollution rights $200 $100 D 2004 Market for Externality Rights

SOCIETY’S OPTIMAL AMOUNT OF EXTERNALITY REDUCTION MC MB Socially optimum amount of pollution abatement 0 Society’s marginal benefit and marginal cost of pollution abatement Amount of pollution abatement Q1Q1

Apportioning the Tax Burden Benefits-received principle Ability-to-pay principle Types –Progressive Average Rate increases as income increases Ex. Federal Income Tax –Proportional (Flat) Average rate remains the same regardless of income Ex. Corporate Income Tax (35%) –Regressive Average rate declines as income increases Ex. Sales Tax

Incidence and Elasticity

Percent of Families Percent of Income Perfect Equality Complete Inequality Lorenz Curve (actual distribution) Area between the lines shows the degree of income inequality Lorenz curve after taxes and transfers THE LORENZ CURVE