Public Finance ( MPA405 )

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 MPC + MEC = MSC G S = MPC 110 B 10 105 A 100 Price, Benefit, and Cost (Dollars) D = MSB 4.5 5 Tons of Paper Per Year (Millions) 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 Z 45 S = MSC 30 V Price, Benefit, and Cost (Dollars) 25 U H 10 MPB + MEB = MSB 0 Inoculations Per Year (Millions) 10 12

Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output MPBi + MEB = MSB S = MSC F 30 B A 25 Price, Benefit, and Cost (Dollars) 20 MPBi 0 10 12 16 20 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 S’ = MPC + T = MSC S = MPC G 110 B Net Gains in Well-Being 105 Tax Revenue = Total External Costs 100 A T 95 Price, Benefit, and Cost (Dollars) D = MSB 4.5 5 Tons of Paper Per Year (Millions)

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 MPC + MEC = MSC F MPC A P M B Price C D = MSB MR Q Q* 0 M Output per Year

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

Figure 3.6 A Corrective Subsidy Z 45 S = MSC R 30 V Price, Benefit, and Cost (Dollars) 25 U Subsidy Payments X 10 D' = MPB + = MSB $20 Y D = MPB i 0 10 12 Inoculations per Year (Millions) i

Public Finance ( MPA405 )