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