Transcript Negative Externalities

CHAPTER
4
Externalities
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
Definition of an Externality
Economic cost/benefit that is the byproduct of economic activity
 Allocated outside of market system
 There are both negative and positive
externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-2
Public Policy Toward
Externalities

Importance of transactions costs
 Large
numbers = High transactions
 High transactions costs make bargaining
break down

Importance of internalization of
externalities
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-3
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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-4
Negative Externalities in Supply
and Demand Framework
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-5
Private Actions to Correct an
Externality
Small numbers – private exchange may
allow for internalization of externality
 Example: Leaf burning neighbor

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-6
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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-7
Corrective Taxation of an
Externality
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-8
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-9
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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-10
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-11
Taxation versus Regulation
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-12
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-13
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-14
Marketable Pollution Rights
Can help allocate resources more
efficiently
 Can reduce pollution over time without
excess burden
 Less political opposition

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-15
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-16
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-17
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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-18
Positive Externalities
Benefit to others not allocated within
market
 Demand curve does not reflect true value
of activity
 Activity will be under-produced

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-19
Positive Externalities
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-20
Solutions
Subsidies – negative taxes that correct for
positive used externalities
 Optimal subsidy set equal to amount of
external benefit

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-21
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-22
Technological and Pecuniary
Externalities
Technological externalities – directly
affect firm’s production function or
individuals utility function
 Operate outside market system

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-23
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-24
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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-25
Negative Inframarginal
Externalities
A marginal reduction in externality will
not make anyone better off
 Optimal tax is zero

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-26
Negative Inframarginal
Externalities
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-27
Positive Inframarginal
Externalities
Optimal quantity produced without
subsidy
 Example: K-12 Education

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-28
Positive Inframarginal
Externalities
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
4-29