1 1 BA 210 Lesson III.4 ExternalitiesOverviewOverview

2 2 Lesson Overview BA 210 Lesson III.4 Externalities Chapter 17 Externalities Optimal Taxes on Consumption Optimal Taxes on Production Optimal Subsidies on Consumption Optimal Subsidies on Production Controversy: The Value of Human Life Summary Review Questions

3 3 BA 210 Lesson III.4 Externalities Optimal Taxes on Consumption

4 4 BA 210 Lesson III.4 Externalities Introductory Example to Optimal Taxes Suppose cigarettes cost $1.00 to produce each pack, and there are enough competing producers that the no-tax market price equals unit cost, $1.00. Suppose my benefits from smoking are: first pack, $2.30; second, $1.60; third, $1.10; fourth, $0.60; and so on. Suppose your loses from my smoking are $0.40 per pack. Question 1: How many packs do I smoke in the competitive- equilibrium? Is that consumption efficient? (Hint: On the 3 rd pack, I gain $0.10 consumer surplus, but you loose $0.40) Question 2: Name a tax on cigarettes that’s so high that the tax equilibrium is inefficient. (Hint: Without tax, on the 1 st pack, I gain $1.30 surplus and you loose $0.40.) Question 3: Name a tax on a pack of cigarettes that makes the tax equilibrium efficient. (Hint: Compute efficient # of packs?) Optimal Taxes on Consumption

5 5 The Demand and Supply for Cigarettes The height of the demand curve is the marginal benefit from the last pack of cigarettes. It is the value of cigarettes to the last consumer. For example, the marginal benefit of the 5,000 th pack is $10. S D = MB 05,00010,00015,000 $ E Price of a pack of cigarettes Quantity of cigarettes Equilibrium quantity Equilibrium price BA 210 Lesson III.4 Externalities A Optimal Taxes on Consumption

6 6 The Demand and Supply for Cigarettes The height of the supply curve is the marginal cost of the last pack of cigarettes. It is the cost of producing to the last producer. For example, the marginal cost of the 5,000 th pack is $6. S = MC D = MB 05,00010,00015,000 E Price of a pack of cigarettes Quantity of cigarettes Equilibrium quantity Equilibrium price BA 210 Lesson III.4 Externalities B Optimal Taxes on Consumption $

7 7 A Negative Externality in Consumption can be analyzed by a decrease in the marginal social benefit of consumption below the marginal benefit to consumers. (If a smoker benefits $8.20 and non-smokers lose $4.00, then society as a whole benefits $4.20) S = MC D = MB 05,00010,00015,000 E Price of a pack of cigarettes Quantity of cigarettes BA 210 Lesson III.4 Externalities Optimal Taxes on Consumption $ MSB MSB curve shifts downward by the amount of the externality --- the marginal external effect

8 8 Total surplus is maximal (optimal) when marginal social benefit equals marginal cost. A Pigouvian tax on consumers lowers their marginal benefit to equal MSB, and so equilibrium quantity is optimal. S = MC D = MB 05,00010,00015,000 Buyers’ price of a pack of cigarettes Quantity of cigarettes BA 210 Lesson III.4 Externalities B Optimal Taxes on Consumption $ MSB Pigouvian tax = $4 per unit A

9 9 Optimal (Pigouvian) Taxes on Consumption equal the marginal external effect of the last unit consumed. Without the tax, equilibrium quantity is too high, and it is possible to make everyone better off by reducing consumption. BA 210 Lesson III.4 Externalities Optimal Taxes on Consumption

10 BA 210 Lesson III.4 Externalities Optimal Taxes on Production

11  Pollution is a bad thing. Yet most pollution is a side effect of activities that provide us with good things, such as steel.  Pollution is a side effect of useful activities, so the optimal quantity of pollution isn’t zero.  Then, how much pollution should a society have? What are the costs and benefits of pollution? BA 210 Lesson III.4 Externalities Optimal Taxes on Production

12 The Demand and Supply for Steel The height of the demand curve is the marginal benefit from the last ton of steel. It is the value of steel to the last consumer. For example, the marginal benefit of the 5,000 th ton is $100. S D = MB 05,00010,00015,000 $ E Price of a ton of steel Quantity of steel Equilibrium quantity Equilibrium price BA 210 Lesson III.4 Externalities A Optimal Taxes on Production

13 The Demand and Supply for Cigarettes The height of the supply curve is the marginal cost of the last ton of steel. It is the cost of producing to the last producer. For example, the marginal cost of the 5,000 th ton is $60. S = MC D = MB 05,00010,00015,000 E Price of a ton of steel Quantity of steel Equilibrium quantity Equilibrium price BA 210 Lesson III.4 Externalities B $ Optimal Taxes on Production

14 A Negative Externality in Production can be analyzed by an increase in the marginal social cost of production above the marginal cost to producers. (If producers’ costs are $82 and the environmental costs are $40, then societies’ costs are $122.) S = MC D = MB 05,00010,00015,000 E Price of a ton of steel Quantity of steel BA 210 Lesson III.4 Externalities MSC MSC curve shifts upward by the amount of the externality --- the marginal external effect $ Optimal Taxes on Production

15 Total surplus is maximal (optimal) when marginal benefit equals marginal social cost. A Pigouvian tax on producers raises their marginal cost to equal MSC, and so equilibrium quantity is optimal. S = MC D = MB 05,00010,00015,000 Price of a ton of steel Quantity of steel BA 210 Lesson III.4 Externalities B Pigouvian tax = $40 per unit A $ MSC Optimal Taxes on Production

16 Optimal (Pigouvian) Taxes on Production equal the marginal external effect of the last unit produced. Without the tax, equilibrium quantity is too high, and it is possible to make everyone better off by reducing production. BA 210 Lesson III.4 Externalities Optimal Taxes on Production

17 BA 210 Lesson III.4 Externalities Optimal Subsidies on Consumption

18 The Demand and Supply for Flu Shots The height of the demand curve is the marginal benefit from the last flu shot. It is the value of a flu shot to the last consumer. For example, the marginal benefit of the 10,000 th shot is $4. S 05,00010,00015,000 $ Price of a flu shot Quantity of flu shots Equilibrium quantity Equilibrium price BA 210 Lesson III.4 Externalities Optimal Subsidies on Consumption D = MB E A

19 The Demand and Supply for Flu Shots The height of the supply curve is the marginal cost of the last flu shot. It is the cost of producing to the last producer. For example, the marginal cost of the 10,000 th shot is $8. 05,00010,00015,000 $ B Price of a flu shot Quantity of flu shots Equilibrium quantity BA 210 Lesson III.4 Externalities Optimal Subsidies on Consumption D = MB E Equilibrium price S = MC

20 A Positive Externality in Consumption can be analyzed by an increase in the marginal social benefit of consumption below the marginal benefit to consumers. (If a patient benefits $4.20 and others benefits $4.00, then society as a whole benefits $8.20) S = MC MSB 05,00010,00015,000 Price of a flu shot Quantity of flu shots BA 210 Lesson III.4 Externalities $ D = MB MSB curve shifts upward by the amount of the externality --- the marginal external effect Optimal Subsidies on Consumption E

21 Total surplus is maximal (optimal) when marginal social benefit equals marginal cost. A Pigouvian subsidy on consumers raises their marginal benefit to equal MSB, and so equilibrium quantity is optimal. S = MC D = MB 05,00010,00015,000 Buyers’ price of a flu shot Quantity of flu shots BA 210 Lesson III.4 Externalities $ MSB Pigouvian subsidy = $4 per unit Optimal Subsidies on Consumption B A

22 Optimal (Pigouvian) Subsidies on Consumption equal the marginal external effect of the last unit consumed. Without the tax, equilibrium quantity is too low, and it is possible to make everyone better off by increasing consumption. BA 210 Lesson III.4 Externalities Optimal Subsidies on Consumption

23 BA 210 Lesson III.4 Externalities Optimal Subsidies on Production

24 The Demand and Supply for Honey The height of the demand curve is the marginal benefit from the last case of honey. It is the value of honey to the last consumer. For example, the marginal benefit of the 10,000 th case is $80. D = MB 05,00010,00015,000 $ A Price of a case of honey BA 210 Lesson III.4 Externalities E Optimal Subsidies on Production Equilibrium quantity S Equilibrium price Quantity of honey

25 The Demand and Supply for Cigarettes The height of the supply curve is the marginal cost of the last ton of steel. It is the cost of producing to the last producer. For example, the marginal cost of the 10,000 th case is $120. D = MB 05,00010,00015,000 Price of a case of honey Quantity of honey Equilibrium quantity Equilibrium price BA 210 Lesson III.4 Externalities $ Optimal Subsidies on Production E B S = MC

26 A Positive Externality in Production can be analyzed by an decrease in the marginal social cost of production below the marginal cost to producers. (If producers’ costs are $122 and the environmental benefits to plants are $40, then societies’ costs are $82.) MSC D = MB 05,00010,00015,000 Price of a case of honey Quantity of honey BA 210 Lesson III.4 Externalities S = MC MSC curve shifts downward by the amount of the externality --- the marginal external effect $ Optimal Subsidies on Production E

27 Total surplus is maximal (optimal) when marginal benefit equals marginal social cost. A Pigouvian tax on producers lowers their marginal cost to equal MSC, and so equilibrium quantity is optimal. MSC D = MB 05,00010,00015,000 Price of a case of honey Quantity of honey BA 210 Lesson III.4 Externalities Pigouvian subsidy = $40 per unit $ S = MC Optimal Subsidies on Production B A

28 Optimal (Pigouvian) Subsidies on Production equal the marginal external effect of the last unit produced. Without the subsidy, equilibrium quantity is too lower, and it is possible to make everyone better off by increasing production. BA 210 Lesson III.4 Externalities Optimal Subsidies on Production

29 Controversy: Value of Human Life BA 210 Lesson III.4 Externalities Controversy: Value of Human Life

30 BA 210 Lesson III.4 Externalities There are several practical problems to overcome when measuring the harmful marginal external effect of negative externalities like smoking cigarettes or producing pollution. If, say, the last cigarette pack increased by % the chance of people near you dying of cancer, you must place a dollar value on their lives to determine the optimal tax. Controversy: Welfare

31 BA 210 Lesson III.4 Externalities What is the dollar value of someone's life? Is it infinity? --- as Catholics and lawyers tell us. Maybe they are right, but as economists we work under the assumption of rationality. Someone's life has the same value that they place on it. Controversy: Welfare

32 BA 210 Lesson III.4 Externalities For example, suppose that by inspecting your roof yourself, rather than having someone else do it for you, you save $20, but increase your chance of death (by falling) by %. Consider these implications: Since rich people do not find $20 enough incentive to inspect their own roofs, the value of their lives is more than $20. Since poor people do find $20 enough incentive to inspect their own roofs, the value of their lives is less than $20. In particular, the cost of risking a rich person's life is greater than the cost of risking a poor person's life. Controversy: Welfare

33 BA 210 Lesson III.4 Externalities The optimal tax on various negative externalities is affected by the difference in cost of risking a rich person's life and risking a poor person's life:  Drunk and reckless driving and speeding should be more heavily enforced and punished in rich neighborhoods.  Dumping toxic waste should be more heavily restricted and punished in rich neighborhoods. Controversy: Welfare

34 BA 210 Lesson III.4 ExternalitiesSummarySummary

35 Review Questions BA 210 Lesson III.4 Externalities Review Questions  You should try to answer some of the following questions before the next class.  You will not turn in your answers, but students may request to discuss their answers to begin the next class.  Your upcoming cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exam.

36 Review Questions BA 210 Lesson III.4 Externalities Follow the link for review questions for Lesson III.4

37 BA 210 Lesson III.4 Externalities Review Questions Review Question 1

38 BA 210 Lesson III.4 Externalities Review Questions Question 1. To understand how to promote social behavior, consider the lifetime demand for flu shots by a typical (selfish) person: Suppose the marginal cost of producing flu shots is $1.20 per shot. Suppose that each person has 2 co-workers, and each benefits by $0.10 for each shot the person takes. If the government imposes the optimal subsidy, how many shots does each person take? $ price per shot Shots demanded

39 BA 210 Lesson III.4 Externalities Review Questions Answer 1. Since shots are an example of a positive consumption externality, use this formula: (Optimal subsidy) = (marginal external effect on everyone else). Hence, given the data, (Efficient subsidy) = 2 × 0.10 = 0.20 Hence, the buyer’s price falls from 1.20 to 1.20−.20 = Conclusion: Reading from the demand curve, 5 shots are taken by each person. $ price per shot Shots demanded

40 BA 210 Lesson III.4 Externalities Review Questions Review Question 2

41 BA 210 Lesson III.4 Externalities Review Questions Question 2. To understand how to control anti-social behavior, consider a world with 6 people: 1 drinks and drives, 5 do not drink. Here is the demand for shots of whisky by the drinker. Suppose each of the 5 drink-haters loses $0.05 of happiness for each pint the drinker drinks. (The cost includes the chance of being killed by the drunk driver.) Suppose the unit cost of producing whisky is $0.40 per shot, and the market is perfectly competitive. $ price per shot Shots demanded

42 BA 210 Lesson III.4 Externalities Review Questions Assuming there are no taxes or subsidies, compute total surplus. Assuming the government imposes the optimal tax, compute the number of shots of whisky that are drunk. Assuming the government imposes the optimal tax, then compute total surplus. $ price per shot Shots demanded

43 BA 210 Lesson III.4 Externalities Review Questions Answer 2. Since the market is perfectly competitive, the sellers’ price of whisky is $0.40 per shot. Assuming there are no taxes or subsidies, consumption = 6, producer surplus = 0, consumer surplus = minus 5 x 0.05 x 6 = $2.10, So total surplus is $2.10 $ price per shot Shots demanded

44 BA 210 Lesson III.4 Externalities Review Questions Assuming the government imposes the optimal tax = marginal external effect = 5 x 0.05 per shot, the buyers’ price of whisky is = $0.65 per shot, so 5 shots of whisky are drunk. Assuming the government imposes the optimal tax, consumption = 5, producer surplus = 0, consumer surplus = = $2.35, Since the tax revenue balances the external effect, the optimal tax increased total surplus to $2.35 $ price per shot Shots demanded

45 BA 210 Lesson III.4 Externalities Review Questions Review Question 3

46 BA 210 Lesson III.4 Externalities Review Questions Question 3. To understand how to control anti-social behavior, consider a world with 9 people: 1 smokes, 3 do not care about smoke, 5 hate the smell of smoke. Here is the demand for cigarettes by the smoker. Suppose each of the 5 smoke-haters loses $0.10 of happiness for each pack the smoker smokes.(The cost includes the chance of dying from second-hand smoke.) Suppose the unit cost of producing cigarettes is $0.20 per pack, and the market is perfectly competitive. $ price per pack Packs demanded

47 BA 210 Lesson III.4 Externalities Review Questions Assuming there are no taxes or subsidies, compute total surplus. Assuming the government imposes the optimal tax, compute the number of shots of whisky that are drunk. Assuming the government imposes the optimal tax, then compute total surplus. $ price per pack Packs demanded

48 BA 210 Lesson III.4 Externalities Review Questions Answer 2. Since the market is perfectly competitive, the sellers’ price of cigarettes is $0.20 per pack. Assuming there are no taxes or subsidies, consumption = 7, producer surplus = 0, consumer surplus = x 0.10 x 7 = $1.30, So total surplus is $1.30 $ price per pack Packs demanded

49 BA 210 Lesson III.4 Externalities Review Questions Assuming the government imposes the optimal tax = marginal external effect = 5 x 0.10 per pack, the buyers’ price of cigarettes is = $0.70 per pack, so 5 packs are smoked. Assuming the government imposes the optimal tax, consumption = 5, producer surplus = 0, consumer surplus = = $2.10, Since the tax revenue balances the external effect, the optimal tax increased total surplus to $2.10 $ price per pack Packs demanded

50 End of Lesson III.4 BA 210 Lesson III.4 Externalities BA 210 Introduction to Microeconomics