Assume that chemical firms generate pollution. A study found that the firms’ pollution is negatively affecting the environment. The study was read by several politicians and they have requested to the government to impose a tax. Politicians expect to observe a decrease in the environmental damage (specifically, eliminate the deadweight loss). Please find the optimal tax that the government should impose in this chemical market. Emission Fee – Negative Externality 1 Without Tax (1) Demand MC E MC P =S MC S With Tax (2) TAX=8-7=1 Net Social Benefit (NSB) with Tax= Consumer Surplus (CS) + +GR Producer Surplus (PS) -Cost of Externality (CE) Government Revenue

Positive Externalities MSB>MPB How might public policy correct for the economic inefficiency resulting from underproduction with a positive externality? Supply (MC) MB P Price Market Quantity Q1Q1 P1P1 MB E MB S =MP B +MB E PSPS Q*Q* P*P* Optimal Subsidy Per Unit Eq. With Subsidy MSB at Q1 Government cost from Subsidy Net Social Benefit = CS + PS+ BE+ Government Cost

Common Property (Congestion Toll) Price Quantity Peak-Demand Off-Demand MC E MC P MC S Q5Q5 Q4Q4 Q3Q3 Q2Q2 Q1Q1 MC E =MC S No Congestion Optimal Peak Toll

Exercise - Positive Externality The production of Honey usually generates a side effect or positive externality. That is, the pollination of surrounding crops by the bees. In some cases, the value generated by the pollination may be more important than the value of the harvested honey. In order to promote this activity, the government sets a subsidy for the honey industry. Assume that the market demand is: Demand (MB P ): P=10-q MB E =5-1/2q MC=q Determine the government cost from the subsidy and the CS and Producer surplus (before and after subsidy)

Examples

Gasoline Taxes (cents per gallon) July API In average, state and local taxes add 31.1 cents to gasoline for a total US average fuel tax of 49.5 cents per gallon for gas (April 2012).

Subsidies Ethanol subsidies: Since 1980 the ethanol industry was awarded an estimated US$45 billion in subsidies. The U.S. Congress did not extend the tariff and the tax credit, allowing both to end on December 31, Fossil-Fuel subsidies: The Environmental Law Institute (2009) estimated that subsidies to fossil-fuel based sources amounted to approximately $72 billion over period and subsidies to renewable fuel sources totaled $29 billion. [Annual tax deductions] Higher Education subsidies: The Department of Education spends about $30 billion a year on subsidies for higher education. The bulk of that funding goes toward student aid programs. [Budget of the U.S. Government, Fiscal Year 2009]