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Public Finance, Chapter 3

The document defines externalities as activities of one entity that directly affect another entity outside of market forces, whether positively or negatively. Examples of negative externalities include pollution and congestion, while positive externalities include research and development. Externalities arise because there is no market price attached to the activity. The economist's approach to pollution is for the government to charge polluters a price through taxes or permits to discourage pollution and reach the socially optimal level of pollution. Graphical analysis shows how taxes or permits can shift supply curves to account for marginal damage from pollution and maximize social welfare. The optimal tax or permit price equals the marginal damage from pollution.

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YIN SOKHENG
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631 views

Public Finance, Chapter 3

The document defines externalities as activities of one entity that directly affect another entity outside of market forces, whether positively or negatively. Examples of negative externalities include pollution and congestion, while positive externalities include research and development. Externalities arise because there is no market price attached to the activity. The economist's approach to pollution is for the government to charge polluters a price through taxes or permits to discourage pollution and reach the socially optimal level of pollution. Graphical analysis shows how taxes or permits can shift supply curves to account for marginal damage from pollution and maximize social welfare. The optimal tax or permit price equals the marginal damage from pollution.

Uploaded by

YIN SOKHENG
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter 3

Externalities and the Environment


Prepared and Taught by Lecturer: YIN SOKHENG, Master in Finance

Externality Defined
An externality is present when the activity of one entity (person or firm) directly affects the welfare of another entity in a way that is outside the market mechanism. Negative externality: These activities impose damages on others. Positive externality: These activities benefits on others.

Instructed by YIN SOKHENG, Master in Finance

Examples of Externalities
Negative Externalities Pollution Cell phones in a movie theater Congestion on the internet Drinking and driving Student cheating that changes the grade curve Positive Externalities Research & development Vaccinations A neighbors nice landscape Students asking good questions in class Not Considered Externalities Land prices rising in urban area Known as pecuniary externalities
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Instructed by YIN SOKHENG, Master in Finance

Nature of Externalities
Arise because there is no market price attached to the activity Can be produced by people or firms Can be positive or negative Public goods are special case
Positive externalitys full effects are felt by everyone in the economy

Instructed by YIN SOKHENG, Master in Finance

The Economists Approach to Pollution


The govt. charge polluters a price in order to discourage pollution. The govt. can charge a price in two way: by a tax and by a permit price.
Tax method: The govt. sets a tax per unit of pollutant X. Permit method: The govt. decides the aggregate quantity of pollutant X it is willing to tolerate.

Instructed by YIN SOKHENG, Master in Finance

Figure 3.1 The Trade-Off between Output and Environmental Quality


A Environmental quality B C D C A B

E F Output
Instructed by YIN SOKHENG, Master in Finance

E F Q
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Pollution Tax Analysis


For example: A competitive market is governed by demand and supply, as shown for gasoline in Figure 3.2.
The market will go to the intersection point: The price of gasoline will turn out to be $3.50, and the quantity actually bought and sold will be 100 gallons.

Instructed by YIN SOKHENG, Master in Finance

Graphical Analysis
MB = marginal benefit to the firm MPC = marginal private cost to the firm MD = marginal damage to the environment MSC = MPC+MD = marginal social cost The firm maximizes profits at MB=MPC. This quantity is denoted as Q1. Social welfare (socially optimal) is maximized at MB=MSC, which is denoted as Q* .
Instructed by YIN SOKHENG, Master in Finance
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Figure 3.2 The Social Optimal Quantity of a Polluting Good


P MSC S (MPC) J

I $3.50 H K

D (MB) Q 80 100 gallons


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Instructed by YIN SOKHENG, Master in Finance

Graphical Analysis
Figure 3.2 MB = MPC : Optimal Quantity 100 units =The firm maximizes profits MD = $1 MSC = MPC+MD: marginal social cost MB = MSC: Social welfare (socially optimal Quantity) is maximized at 80 units

Instructed by YIN SOKHENG, Master in Finance

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Graphical Analysis,
The Optimal Tax Equals the Marginal Damage

Figure 3.3: T = MD = $1 The effect of a $1 tax per unit would be to shift up the supply curve by $1 because the tax would increase the marginal private cost seller have to pay by $1. If T = MD, the reduction in the polluting good from 100 to 80 units confers a net benefit on society. Gross benefit, HIJK = $1 x 20 = $20
Instructed by YIN SOKHENG, Master in Finance
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Figure 3.3 The Optimal Tax Equals the Marginal Damage


P S (MPC) S (MPC) J

I $3.50 H K

D (MB) Q 80 100
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Instructed by YIN SOKHENG, Master in Finance

Graphical Analysis,
The Net Benefit from the Optimal Tax Figure 3.4 If the environmental benefit were not counted, the cutback would impose a loss the economy; that loss would equal the area HIK. The losses over all units cut gives the area HIK; the area of HIK = ($1 x 20) = $10 Hence the net benefit to society of the cutback equal the area IJK = HIJK HIK = $20 $10 = $10
Instructed by YIN SOKHENG, Master in Finance
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Figure 3.4 The Net Benefit from the Optimal Tax


P MSC S (MPC) J

I $3.50 H K

D (MB) Q 80 100
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Instructed by YIN SOKHENG, Master in Finance

To Maximize Cost, Levy the Same Tax on All Firms Emitting Pollution X This section demonstrates a point that is of the utmost importance for public policy. To maximize the cost of achieving a given reduction in pollution X, the same tax per emission should be levied on all firms emitting pollution X. If the government sets the tax T equal to the marginal damage MD, what the firms then do for profit will unintentionally be what is best for society.
Instructed by YIN SOKHENG, Master in Finance
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Graphical Analysis
Figure 3.5: For example, Firm H (the high abatement cost firm) move left from 50 emissions, its MACH rises sharply. Firm L (the low abatement cost firm) move left from 50 emissions, its MACL rises slowly. MD = $40 per emissions For each firm, staring from an emissions level of 50, each unit abate entails a higher marginal abatement cost (MAC).
Instructed by YIN SOKHENG, Master in Finance
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Figure 3.5 The Optimal Cutback of Pollution


$200 MACH

$100

$60 $50 $40 $25 $20

MACL

MD T = MD = $40 10 25 30 35 40 45 50 Emissions
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Instructed by YIN SOKHENG, Master in Finance

Trade Permits (permit market)


Instead of levying a tax, suppose the government requires firms to have a permit for each unit of pollution that it emits. Figure 3.6; as shown, the government decided to supply 50 permits. The government would adjust its tentative price until it arrives at a final price of $40.

Instructed by YIN SOKHENG, Master in Finance

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Figure 3.6 The Permit Market


$200 DH

$60 $50 $40 $20

DL D

10

30 35 40 45 50 Permits

75
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Instructed by YIN SOKHENG, Master in Finance

So at a price of $40, L would demand 10 permits, and H, 40 permits, so total demand would be 50 permits. If the price were $20, DL would be 30 and DH, 45, so D would be 75. For any price < $40 => D > S (50) If price > $50 => DL = 0, so D = DH For any price > $40 => D < S (50) Thus, the government would adjust its tentative price until it arrives at a final price of $40.
Instructed by YIN SOKHENG, Master in Finance
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The government should collect the same total revenue - $40 times the number of emissions (50 units), or $2000. Giving permits to polluting firs will also shift up the supply (decrease) curve of each polluting good and thereby raise the price of polluting goods, just like selling permits or levying a tax.

Instructed by YIN SOKHENG, Master in Finance

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Table 3.1 Demand for Extra Permits and Supply of Excess Permits
Gift from the Government: L 25, H 25 permits
P $20 $40 $60 L emits 30 10 0 Ls gift 25 25 25 L demands 5 0 0 L supplies 0 15 25 H emits 45 40 35 Hs gift 25 25 25 H demands 20 15 10 H supplies 0 0 0

Gift from the Government: L 45, H 45 permits


P $20 $40 $60 L emits Ls gift L demands L supplies H emits Hs gift H demands H supplies

Instructed by YIN SOKHENG, Master in Finance

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Gift from the Government: L 5, H 45 permits


P $20 $40 $60 L emits Ls gift L demands L supplies H emits Hs gift H demands H supplies

The End

Instructed by YIN SOKHENG, Master in Finance

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