Public Finance (MPA405) Dr. Khurrum S. Mughal

Lecture 4: Externalities and Public Policy Public Finance

Externalities I - What are externalities ? II - Externalities and efficiency III – Internalization of externalities –1- Corrective taxes –2- Second best efficiency solutions –3- Corrective subsidies –4- Property rights and Coase Theorem –5- Efficient abatement level –6- Regulatory solutions

I- Externalities Externalities are costs or benefits of market transactions not reflected in prices. –Negative externalities are costs to third parties. –Positive externalities are benefits to third parties. Real and pecuniary externalities

II- Externalities and Efficiency The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good. This occurs when there is a negative externality.

Social Costs MSC = MPC + MEC

Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency D = MSB S = MPC MPC + MEC = MSC 10 Price, Benefit, and Cost (Dollars) Tons of Paper Per Year (Millions) A B G 10

Implications of Figure 3.1 Market equilibrium occurs where MPC = MSB Efficiency Requires that MSC = MPC + MEC = MSB

Positive externalities The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production of consumption of a good. This occurs when there is a positive externality.

Social Benefit MSB = MPB + MEB

Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency S = MSC MPB + MEB = MSB H Z U V Price, Benefit, and Cost (Dollars) Inoculations Per Year (Millions)

Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output B F A S = MSC MPB i MPB i + MEB = MSB Price, Benefit, and Cost (Dollars) Inoculations per Year (Millions)

III- Internalization of Externalities An externality can be internalized if there is a policy that causes market participants to account for the costs of benefits of their actions. Requires: –to indentify the participants –Monetary value of External Cost or Benefit Controversy

1- Corrective Taxes to Negative Externalities Setting a tax equal to the MEC will internalize a negative externality.

Figure 3.4 A Corrective Tax Price, Benefit, and Cost (Dollars) Tons of Paper Per Year (Millions) D = MSB S = MPC A S’ = MPC + T = MSC Tax Revenue = Total External Costs T Net Gains in Well-Being G B

Results of a Corrective Tax Socially optimal levels of production are achieved. The tax revenue is sufficient to pay costs to third parties. –$45 Million in this case Alternative methods of dumping, adding MEC to MPC A policy supported by one group and not the other

Using a Corrective Tax The greenhouse effect and a “Carbon Tax” –If it is accepted that the greenhouse effect is caused by burning carbon-based fuels, a carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels. –It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel. –Debated Issue Higher costs due to environment damage in future Increase in prices of other goods to avoid use of coal

2- Theory of the Second Best –A polluting Monopolist A dillema

A Polluting Monopolist –Earlier it was shown that monopoly created a loss to society. –It was shown that a negative externality causes a loss as well. –The losses do not necessarily add to one another. In fact, they can cancel each other out.

2- Theory of the Second Best –When one condition for an optimum is violated then maintaining the others will not guarantee a second-best solution.

Figure 3.5 A Second Best Efficient Solution D = MSB MPC MPC + MEC = MSC MR Price Output per Year 0 Q M Q* P M A F B C

3- Corrective Subsidies Setting a subsidy equal to MEB will internalize a positive externality For example: –Garbage collection, tree plantation

Subsidy Payments Figure 3.6 A Corrective Subsidy i i Y D = MPB D' = MPB + $20 = MSB S = MSC Price, Benefit, and Cost (Dollars) Inoculations per Year (Millions) Z V R X U