economics 4315/7315: public economicsauras/teaching/315lectures/lecture4.pdfanalytics of the optimal...
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Economics 4315/7315: Public Economics
Saku Aura
Department of Economics - University of Missouri
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Externalities:
An effect of an agent’s action to another agent’s outcome
agent={firm, consumer}outcome={profit,utility}
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Pecuniary vs non pecuniary
Two types:1 Pecuniary externality
Externality through market mechanism
2 Non-Pecuniary
Externality outside market mechanism
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Pecuniary vs non pecuniary example:
Pecuniary externality:Town A suddenly becomes a popular place to live. Real estateprices go up because the new residents bid up prices. Currentproperty owners benefit while current renters suffer.
Non-pecuniary externality:Town A suddenly becomes a popular place to live. Suddenly theroads, libraries, public schools and parks are too crowded for old(and new) resident to enjoy their benefits fully.
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Non-pecuniary externalities
Pecuniary externality is not a market failure –> first welfaretheorem holdsNon-pecuniary externality leads to a market failures–> first welfaretheorem fails
From now on:Externality = non-pecuniary externality
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Examples of negative externalities
Environmental externalities:NoiseChemical pollution (local, global)
CongestionAntibiotic Use
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Examples of positive externalities
Research and DevelopmentBasic Research (externality vs public good)VaccinationsAntibiotic use
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Running example (adapted from Rosen’stextbook):
Lisa: Commercial FisherBart: Factory ownerCommon Resource
River: negative externality from the factory
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Lack of property rights
1 If Lisa owned the river –> She could charge Bart for pollution2 If Bart owned the river –> Lisa could pay Bart not to pollute
Both cases would be efficient (Coase theorem)
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Free market outcome
$
Q
MC
MB=Marginal Benefits
MD=Marginal damages
Q*
Bart's surplus
Environmentaldamage
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Optimal allocation
$
Q
MC
MB
MD
Q*
SMC=Social Marginal Cost
Positive Social Surplus
Negative Social Surplus
Efficient level ofPollution
Qeff.
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Analytics of the optimal allocation
Social Marginal Cost = Private Marginal BenefitsEquivalently: Social Marginal Benefits = Private Marginal Cost
ExampleMarginal Cost=4Marginal Benefit=10− QNegative Externality=1 –> Social Marginal Cost=5Free market outcome: Q = 6
Optimal: Q = 5
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Practical issues with environmentalexternalities
1 Objective Uncertainty over Externalities (physical effects)Example Global Warming and CO2
2 Economic Effects of the Physical Effects:Contingent ValuationHedonic Pricing
3 ”Fine tuning” policy to complex externalitiesDriving example
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Contingent valuation
Consumer valuations in a survey of (say) hypothetical environmentalquality improvementsProblems:
Hypothetical questions –> hypothetical answersframing matters’Elephants in Africa’ problem
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Hedonic pricing
Air Quality example:
House A & B equal in every aspect, except A is in a”clean air”neighborhood while B is in a ”dirty air” neighborhoodNeighborhoods should be otherwise similar
Market price (rental price or sales price) gives the market valuationof clean air
In practice: Hard regression analysis problem (no two neighborhoodsare otherwise similar)
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”Fine tuning” policy: externalities from driving
Some externalities from driving:1 Congestion2 Air pollution (local)3 CO2 and other global pollutants
A single instrument (e.g. gas tax) does not address all of thesecorrectly
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Coase theorem
Two assumptions1 Cost of bargaining low (number of parties involved small)2 Property rights are well defined
Result: Efficiency should prevail and it is independent of theownership of the assets and ”environmental rights”
One practical application of the Coase theoremR&D, ”Synergies” and mergers
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Pigouvian taxes:
Taxes correcting for market failuresTax revenue is a secondary considerationTheory of the Pigouvian subsidies (paying polluters not to pollute)similar
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Pigouvian tax: optimal tax
$
Q
MC
MB
SMCEfficient level ofPollution
Qeff.
MD
MC+tax
Unit tax=MD at the optimum
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Pigouvian tax: social surplus and revenue
$
Q
MC
MB
SMCEfficient level ofPollution
Qeff.
MD
MC+tax
+
+
Social Surplus
Tax Revenue
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Pigouvian tax: exampleAssumptions
Marginal Cost = 20QNegative externality = 5QMarginal Private benefit = 100
ResultsFree market: Q = 5, P = 100
Optimal allocation: Q = 4
Externality at the optimum = 20Corrective tax = 20Price of the good 80 + 20 = 100
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Multi-source pollution and cost of reduction
Efficiency Rule: Equal marginal cost of reduction across sources
$
PollutionReduction
MC(1) MC(2) MC(Total)
Qeff
MC=Marginal Cost ofpollution reduction
SMB=MD=Marginal Damage
SMB=MD
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Uncertainty
Very simple presentation of the marginal cost of reductionuncertainty
Note this gives the market response to (say) a tax
Working assumption is that the marginal cost=MC(1)Analyze the consequence of the true marginal cost of MC(2)
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Inelastic marginal damage
Taxes relatively efficient
$
PollutionReduction
MC(1)
MC(2)
Qeff
MD
Deadweight lossof a tax
Deadweight lossof regulation
t=tax
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Elastic marginal damage
Regulation more efficient
$
PollutionReduction
MC(1)
MC(2)
Qeff
MD
Deadweight lossof a tax
Deadweight lossof regulation
t=tax
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Uncertainty: conclusions
Inelastic marginal damage (horizontal) –> environmentalconsequences of missing the target low –> non-environmental costof setting the quantity wrong high –> taxes goodElastic marginal damage (vertical) –> environmental consequencesof missing the target high –> regulation good
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Permission markets
Government sponsored trading scheme to regulate pollutionGovernment either sells or issues permits to pollute that are alsotraded –> market price for pollutionUsed in the US for SO2 (acid rain) control successfullyEU has a carbon trading scheme (global warming)
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Comparison of policy tools
Efficient allocation Certain amount Taxacross multiple of pollution Revenuesources
Direct Regulation No Yes No
Taxes Yes No Yes
Permit Markets Yes Yes Depends onthe politics
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Fiscal externalities
A fiscal externality is an externality from market behavior togovernment’s budget –> Not a proper externalityCan be an added reason to intervene in the markets
Subsidies to college educationIncentives to get a degree are diminished by (progressive) incometaxation: government is a silent partner in educationSubsidizing education (partially?) pays itself back with future taxrevenue
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Self control and ”internalities”
What about smoking, fatty foods, alcohol, drugs and soda?
Smoking, alcohohol and drugs cause regular externalitiesAll of them cause fiscal externalities (e.g. smoking: fires, healthcare cost vs. pension savings)All of them involve self-control issues
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”Internality and hyperbolic discounting”
Hyperbolic discounting: overvaluing the immediate present toomuchInvolves inconsistency: tomorrow I will overvalue tomorrow toomuch, the optimal trade off between tomorrow and two days fromnow changes when we reach tomorrowCauses ”present bias” in behaviorSupported by strong empirical evidenceMarket responses: Christmas Clubs, Gym memberships
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Internality
Addictive goods an additional problem with internalitiesTwo competing theories of addiction: rational addiction theory andtime-inconsistent preferences (hyperbolic discounting)If the former is the right theory, then strong public policy reasonsfor soda taxes, drug prohibition, alcohol taxes etc.
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Double-dividend hypothesis
Pigouvian taxes1 correct externalities2 raise revenue
Double-dividend hypothesisEnvironmental taxes ”doubly” good because the revenue can beused to reduce other distortive taxes
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Double-dividend hypothesis
Double-dividend hypothesis sounds like common senseIn reality it is more often a fallacyTypically there is a trade off between environmental andnon-environmental goals of (tax) policy
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Why no double dividend: an example
Assume the government has a budget need: $1 billion/yearAssume this can be raised with labor income taxes andenvironmental taxesAssume that the taxes have a non-environmental efficiency cost andpotential environmental benefits
Difference from a simple Pigouvian case: the existence of otherdistortive taxes
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Example continued
Assume we start with just labor income taxesDouble dividend: moving towards environmental taxes make boththe environment better and the non-environmental efficiency costlowerMeans that we would want to use environmental taxes fornon-environmental reasonsThe case for this seems extremely weakThe justification for an environmental intervention has to be betterenvironmental quality
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