pub econ lecture 05 externalities

8/3/2019 Pub Econ Lecture 05 Externalities

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Public FinanceDr. Katie Sauer

Externalities



I . Negative ExternalitiesA. Negative Production Externality

Ex: pollution from the production of steel- the steel plant incurs production costs andreceives payment for the steel it sells

- pollution from the plant harms fishermen

The social marginal cost of steel is greater than the

private marginal cost of steel.

SMC = PMC + Marginal Damage



Price

Quantity of Steel

PMC = S

PMB = D= SMB

Qm

Pm

The market outcomewill be where supplyand demand are equal.

The market ignoresexternalities.

The PMC + MD is thetrue cost to society of the action (SMC).

The socially optimaloutcome is a lower quantity.

SMC

Marginal Damage

Qso



Price

Quantity of Steel

PMC = S

PMB = D= SMB

Qm

Pm

The market outcome isinefficient and results indeadweight loss due to

over production.

A corrective tax equal tothe MD would shift thePMC left to coincidewith the SMC.

SMC

Marginal Damage

Qso



B. Negative Consumption Externality

Ex: cigarette smoke- the individual who smokes incurs the costs and

benefits of smoking

- second-hand smoke bothers others- reduces their utility

The social marginal benefit of smoking is less than the private marginal benefit of smoking.

SMB = PMB - Marginal Damage



Price

Quantity

PMC = S= SMC

PMB = D

Qm

Pm

The market outcome will be where supply anddemand are equal.


The PMC - MD is thetrue benefit to society of the action (SMB).

The socially optimaloutcome is a lower quantity.

SMB = PMB - MD

Marginal Damage

Qso



Price

Quantity

PMC = S= SMC

PMB = D

Qm

Pm

SMB = PMB - MD

Marginal Damage

Qso

The market outcome isinefficient and results indeadweight loss due toover consumption.

A corrective tax on

consumers equal to MDwould internalize theexternality.



II . Positive ExternalitiesA. Positive Production Externality

Ex: one firm¶s oil exploration- the firm incurs costs while exploring and alsoreceives benefits from new discoveries

- discovery of new oil reserves offers profitableopportunities for other firms

The social marginal benefit of oil exploration is greater than the private marginal benefit of oil exploration.

SMC = PMC - Marginal Benefit



Price

Quantity of Steel

PMC = S

PMB = D= SMB

Qm

Pm

The market outcome

will be where supplyand demand are equal.


The PMC - MB is thetrue cost to society of the action (SMC).

The socially optimaloutcome is a higher quantity.

SMC =PMC -MB

Marginal Benefit

Qso



Price

Quantity of Steel

PMC = S

PMB = D= SMB

Qm

Pm

SMC =PMC -MB

Marginal Benefit

Qso

The market outcome isinefficient and results indeadweight loss due tounder production.

A subsidy equal to MBwould shift the PMCcurve to the right to

coincide with the SMC.



B. Positive Consumption Externality

Ex: getting a flu shot- the individual incurs the costs and benefits of getting a flu shot

- other people benefit from not getting the flufrom that individual

The social marginal benefit of flu shots is greater than the

private marginal benefit of flu shots.

SMB = PMB + Marginal Benefit



Price

Quantity

PMC = S= SMC

SMB =PMB + MB

Qso

The market outcome will be where supply and

demand are equal.


The PMB + MB is thetrue benefit to society of the action (SMB).

The socially optimaloutcome is a higher quantity.

PMB = D

Marginal Benefit

Qm

Pm



Price

Quantity

PMC = S= SMC

SMB =PMB + MB

Qso

PMB = D

Marginal Benefit

Qm

Pm

The market outcome isinefficient and results indeadweight loss due tounder consumption.

A subsidy to consumers

in the amount of MBwould internalize theexternality.



III . Quantity vs Price Approach to Externalities

Allow abatement technologies to vary.

Basic model: one firm is polluting

What is the optimal level of pollution?



The MD is the additional damage averted by pollutionreduction.

- measures SMB of pollution reduction- flat for simplicity (could be negatively sloped to

show diminishing returns to abatement)



The PMB (D) for pollution reduction is flat at zero.- firm gets no benefit from paying to reduce

pollution



The PMC is the firm¶s private cost of reducing pollution.- slopes up due to diminishing returns

- first unit of pollution reduction is cheaper than last unit of pollution reduction



The PMC = SMC.- there are no externalities from pollution reduction



The market outcome:PMB = PMC

The optimal outcome:SMB = SMC

R* is optimal reduction.

P* is optimal level of pollution.



H ow to get a firm to choose R*?

1. Regulate it

2. implement a tax equal to MD

PMB + MD = SMB

shifts the firm¶s PMB up to coincide with SMB



Now suppose there are two plants, each doing half of the polluting.

400 tons of sludge totalMD = $100 per ton

Plant A is newer than Plant B.- MC of pollution reduction for A is less than thatfor B



MC A + MC B = MC Total

The socially optimal level of pollution reduction is:MC T = MD at 200 units

MD = SMB$100

Cost of PollutionReduction MC B

MC A

4000

PollutionReduction

MC T

50 200



Suppose the government wants to reduce pollution by 200units.

- it could require each firm to reduce its pollution by 100 units

MD = SMB$100


MC A

4000

PollutionReduction

MC T

50 200100



The cost of that reduction is very costly for Plant B and notas costly for Plant A.

MD = SMB$100


MC A

4000

PollutionReduction

MC T

50 200100

PB

PA



A more efficient outcome is to have each plant reduce pollution to the point where MC = MD.

- reduce by 50 for Plant B- reduce by 150 for Plant A

MD = SMB$100


MC A

4000

PollutionReduction

MC T

50 150 200100

PB

PA



I n reality this is hard « the government would needto know each firm¶s individual MC of pollution

reduction.



I nstead of mandating a particular quantity, the governmentcould achieve the same results by imposing a tax equal toMD.

PMB = MC for each firm

MD = SMB$100


MC A

4000

PollutionReduction

MC T

50 150 200100

=PMB B = PMB A

PB

PA



Another option for quantity regulation is to give each firm100 permits allowing each firm to pollute 100 units.

Firms could buy/sell permits among themselves.

MD = SMB$100


MC A

4000

PollutionReduction

MC T

50 150 200100

PB

PA



Firm B would be willing to pay up to P B for permit thatallows it to pollute one more unit (reduce pollution to 99).

Firm A would be willing to accept a minimum of P A

for selling a permit (reduce pollution to 101).

MD = SMB$100


MC A

4000

PollutionReduction

MC T

50 150 200100

PB

PA



IV . Uncertainty

Cost of pollutionreduction could be MC1or MC2.

A. Global Warming

- exact amount of

pollution reduction isn¶tcritical « cumulativeeffect from decades

- Flatish MD



DWL from taxing is lessthan DWL fromregulating reduction.

B. Nuclear Leakage

- very small difference innuclear leakage can makea huge difference

- very steep MD(vertical?)



DWL from taxing is morethan DWL from

regulating reduction.



So, what method should the government choose?

I t depends on whether the goal is

getting the amount of pollution ³right´- regulation

minimizing costs

- taxing

pub econ lecture 05 externalities

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