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

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Tons of Paper Per Year (Millions)

110

105

100

4.5 5

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 = MSBH

Z

U

V

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Inoculations Per Year (Millions)

10

25

30

45

10 120

Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output

B F

A

S = MSC

MPBi

MPBi + MEB = MSB

Pri

ce

, B

en

efi

t, a

nd

Co

st

(Do

llars

)

Inoculations per Year (Millions)

0

30

25

20

10 12 16 20

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 TaxP

rice

, B

enef

it,

and

Co

st (

Do

llar

s)

Tons of Paper Per Year (Millions)

100

5

110

105

95

4.5

D = MSB

S = MPC

A

S’ = MPC + T = MSC

Tax Revenue = TotalExternal Costs

T

Net Gains in Well-Being

GB

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

Pri

ce

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

Pric

e, B

en

efit

, an

d C

ost

(D

olla

rs)

Inoculations per Year (Millions) 0

45

30

25

10

10 12

Z

V R

X

U