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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

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Public finance mpa405

Public Finance (MPA405)

Dr. Khurrum S. Mughal


Lecture 4 externalities and public policy

Lecture 4: Externalities and Public Policy

Public Finance


Externalities

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

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

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

Social Costs

MSC = MPC + MEC


Figure 3 1 market equilibrium a negative externality and efficiency

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

Implications of Figure 3.1

  • Market equilibrium occurs where

    MPC = MSB

  • Efficiency Requires that

    MSC = MPC + MEC = MSB


Positive externalities

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

Social Benefit

MSB = MPB + MEB


Figure 3 2 market equilibrium a positive externality and efficiency

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

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

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

1- Corrective Taxes to Negative Externalities

  • Setting a tax equal to the MEC will internalize a negative externality.


Figure 3 4 a corrective tax

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

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

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

2- Theory of the Second Best

  • A polluting Monopolist

    • A dillema


A polluting monopolist

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 best1

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

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

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

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


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