Definition of an Externality Economic cost/benefit that is the by-product of economic activity Allocated outside of market system There are both negative and positive externalities

Public Policy Toward Externalities Importance of transactions costs Large numbers = High transactions High transactions costs make bargaining break down Importance of internalization of externalities

Negative Externalities Cost imposed on others as by-product of productive activity Allocated outside of market system Market price understates true opportunity cost of production Example: pollution

Negative Externalities in Supply and Demand Framework

Private Actions to Correct an Externality Small numbers – private exchange may allow for internalization of externality Example: Leaf burning neighbor

Corrective Taxation of an Externality Charge a tax equal to external cost results in economically efficient level of output Difficult to estimate total external cost Difficult to determine who is responsible for cost

Corrective Taxation of an Externality

What Should be Taxed? Can reduce external cost in other ways Example: smokestack scrubber Create incentives to reduce amount of externality per unit of production Set tax equal to cost externality imposes on others

Should Compensation be Paid to Those Harmed? Reciprocal nature of problem Proceeds of corrective tax should not be paid as compensation Gives both parties incentive to avoid harm

Taxation versus Regulation Regulation – requires certain steps be taken to reduce externality Taxes and regulations – same effects in short run Reduce output Different effects in long run Regulation creates profits, encourages entry Optimal tax creates losses, encourages exit

Taxation versus Regulation

Politics of Quotas versus Taxes Firms - regulatory solutions more profitable than corrective taxes firms will lobby for regulatory solutions Taxpayers - benefit from corrective taxes Corrective taxes generate additional revenue Does not provide long-run incentive for entry Firms usually have more political influence

Incentives for Regulation versus Taxation Regulatory solution – approximates corrective tax solution in short run Does not give incentive to further reduce externality Corrective tax solution – gives incentive to reduce externality when cost effective Difficult to apply in real world Negative political pressure

Marketable Pollution Rights Can help allocate resources more efficiently Can reduce pollution over time without excess burden Less political opposition

Marketable Pollution Rights Established by giving firms rights to create certain amount of pollution Rights can be bought and sold Buy rights to increase pollution Sell rights when pollution reduced Example: Clean Air Act of 1990

Politics and Pollution Control Corrective taxes and regulation Impose costs on existing polluters Create opposition Marketable rights Imposes no additional costs Incentive to reduce pollution

Optimal Amount of Pollution Weigh marginal benefits against marginal costs Zero pollution is not optimal Negative externalities cited as reason for government involvement in economy

Positive Externalities Benefit to others not allocated within market Demand curve does not reflect true value of activity Activity will be under-produced

Positive Externalities

Solutions Subsidies – negative taxes that correct for positive used externalities Optimal subsidy set equal to amount of external benefit

Excess Burden and Excess Benefit Should we subsidize all positive externalities? Should we tax all negative externalities? Excess burden of taxation needs to be considered

Technological and Pecuniary Externalities Technological externalities – directly affect firm’s production function or individuals utility function Operate outside market system

Technological and Pecuniary Externalities Pecuniary externalities – influence market supply and demand conditions No resources allocated outside market system Does not result in misallocation of resources Government involvement can cause resource misallocation

Marginal and Inframarginal Externalities Inframarginal externalities – no marginal benefits/costs Individuals account for benefits/costs of actions at the margin Do not necessarily imply inefficient allocation of resources Do not require policy action

Negative Inframarginal Externalities A marginal reduction in externality will not make anyone better off Optimal tax is zero

Negative Inframarginal Externalities

Positive Inframarginal Externalities Optimal quantity produced without subsidy Example: K-12 Education

Positive Inframarginal Externalities