Holcombe 04

4CHAPTER

Externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe 4-2

Definition of an Definition of an ExternalityExternality

Economic cost/benefit that is the by-Economic cost/benefit that is the by-product of economic activityproduct of economic activity

Allocated outside of market systemAllocated outside of market system There are both negative and positive There are both negative and positive

externalitiesexternalities


Public Policy Toward Public Policy Toward ExternalitiesExternalities

Importance of transactions costsImportance of transactions costs Large numbers = High transactionsLarge numbers = High transactions High transactions costs make bargaining High transactions costs make bargaining

break downbreak down Importance of internalization of Importance of internalization of

externalitiesexternalities


Negative ExternalitiesNegative Externalities

Cost imposed on others as by-Cost imposed on others as by-product of productive activityproduct of productive activity

Allocated outside of market systemAllocated outside of market system Market price understates true Market price understates true

opportunity cost of productionopportunity cost of production Example:Example: pollution pollution


Negative Externalities in Negative Externalities in Supply and Demand Supply and Demand

FrameworkFramework


Private Actions to Private Actions to Correct an ExternalityCorrect an Externality

Small numbers – private exchange Small numbers – private exchange may allow for internalization of may allow for internalization of externalityexternality

Example:Example: Leaf burning neighbor Leaf burning neighbor


Corrective Taxation of an Corrective Taxation of an ExternalityExternality

Charge a tax equal to external costCharge a tax equal to external cost results in economically efficient level of results in economically efficient level of

outputoutput Difficult to estimate total external Difficult to estimate total external

costcost Difficult to determine who is Difficult to determine who is

responsible for costresponsible for cost


Corrective Taxation of an Corrective Taxation of an ExternalityExternality


What Should be Taxed?What Should be Taxed?

Can reduce external cost in other Can reduce external cost in other waysways Example:Example: smokestack scrubber smokestack scrubber

Create incentives to reduce amount Create incentives to reduce amount of externality per unit of productionof externality per unit of production Set tax equal to cost externality imposes Set tax equal to cost externality imposes

on otherson others


Should Compensation be Should Compensation be Paid to Those Harmed?Paid to Those Harmed?

Reciprocal nature of problemReciprocal nature of problem Proceeds of corrective tax should not Proceeds of corrective tax should not

be paid as compensationbe paid as compensation Gives both parties incentive to avoid Gives both parties incentive to avoid

harmharm


Taxation versus Taxation versus RegulationRegulation

Regulation – requires certain steps be Regulation – requires certain steps be taken to reduce externalitytaken to reduce externality

Taxes and regulations – same effects in Taxes and regulations – same effects in short runshort run Reduce outputReduce output

Different effects in long runDifferent effects in long run Regulation creates profits, encourages Regulation creates profits, encourages

entryentry Optimal tax creates losses, encourages exitOptimal tax creates losses, encourages exit


Taxation versus Taxation versus RegulationRegulation


Politics of Quotas versus Politics of Quotas versus TaxesTaxes

Firms - regulatory solutions more Firms - regulatory solutions more profitable than corrective taxesprofitable than corrective taxes firms will lobby for regulatory solutionsfirms will lobby for regulatory solutions

Taxpayers - benefit from corrective taxes Taxpayers - benefit from corrective taxes Corrective taxes generate additional revenueCorrective taxes generate additional revenue Does not provide long-run incentive for entryDoes not provide long-run incentive for entry

Firms usually have more political Firms usually have more political influenceinfluence


Incentives for Regulation Incentives for Regulation versus Taxationversus Taxation

Regulatory solutionRegulatory solution – approximates – approximates corrective tax solution in short runcorrective tax solution in short run Does not give incentive to further Does not give incentive to further

reduce externalityreduce externality Corrective tax solutionCorrective tax solution – gives – gives

incentive to reduce externality when incentive to reduce externality when cost effectivecost effective Difficult to apply in real worldDifficult to apply in real world Negative political pressureNegative political pressure


Marketable Pollution Marketable Pollution RightsRights

Can help allocate resources more Can help allocate resources more efficientlyefficiently

Can reduce pollution over time Can reduce pollution over time without excess burdenwithout excess burden

Less political oppositionLess political opposition


Marketable Pollution Marketable Pollution RightsRights

Established by giving firms rights to Established by giving firms rights to create certain amount of pollutioncreate certain amount of pollution

Rights can be bought and soldRights can be bought and sold Buy rights to increase pollutionBuy rights to increase pollution Sell rights when pollution reducedSell rights when pollution reduced

Example:Example: Clean Air Act of 1990 Clean Air Act of 1990


Politics and Pollution Politics and Pollution ControlControl

Corrective taxes and regulationCorrective taxes and regulation Impose costs on existing pollutersImpose costs on existing polluters Create oppositionCreate opposition

Marketable rightsMarketable rights Imposes no additional costsImposes no additional costs Incentive to reduce pollutionIncentive to reduce pollution


Optimal Amount of Optimal Amount of PollutionPollution

Weigh marginal benefits against Weigh marginal benefits against marginal costsmarginal costs

Zero pollution is not optimalZero pollution is not optimal Negative externalities cited as Negative externalities cited as

reason for government involvement reason for government involvement in economyin economy


Positive ExternalitiesPositive Externalities

Benefit to others not allocated within Benefit to others not allocated within marketmarket

Demand curve does not reflect true Demand curve does not reflect true value of activityvalue of activity

Activity will be under-producedActivity will be under-produced


Positive ExternalitiesPositive Externalities


SolutionsSolutions

SubsidiesSubsidies – negative taxes that – negative taxes that correct for positive used externalitiescorrect for positive used externalities

Optimal subsidy set equal to amount Optimal subsidy set equal to amount of external benefitof external benefit


Excess Burden and Excess Burden and Excess BenefitExcess Benefit

Should we subsidize all positive Should we subsidize all positive externalities?externalities?

Should we tax all negative Should we tax all negative externalities?externalities? Excess burden of taxation needs to be Excess burden of taxation needs to be

consideredconsidered


Technological and Technological and Pecuniary ExternalitiesPecuniary Externalities

Technological externalities – directly Technological externalities – directly affect firm’s production function or affect firm’s production function or individuals utility functionindividuals utility function

Operate outside market systemOperate outside market system


Technological and Technological and Pecuniary ExternalitiesPecuniary Externalities

Pecuniary externalities – influence Pecuniary externalities – influence market supply and demand market supply and demand conditionsconditions No resources allocated outside market No resources allocated outside market

systemsystem Does not result in misallocation of Does not result in misallocation of

resourcesresources Government involvement can cause Government involvement can cause

resource misallocationresource misallocation


Marginal and Marginal and Inframarginal Inframarginal ExternalitiesExternalities

Inframarginal externalities – no Inframarginal externalities – no marginal benefits/costsmarginal benefits/costs Individuals account for benefits/costs of Individuals account for benefits/costs of

actions at the marginactions at the margin Do not necessarily imply inefficient Do not necessarily imply inefficient

allocation of resourcesallocation of resources Do not require policy actionDo not require policy action


Negative Inframarginal Negative Inframarginal ExternalitiesExternalities

A marginal reduction in externality A marginal reduction in externality will not make anyone better offwill not make anyone better off

Optimal tax is zeroOptimal tax is zero


Negative Inframarginal Negative Inframarginal ExternalitiesExternalities


Positive Inframarginal Positive Inframarginal ExternalitiesExternalities

Optimal quantity produced without Optimal quantity produced without subsidysubsidy

Example:Example: K-12 Education K-12 Education


Positive Inframarginal Positive Inframarginal ExternalitiesExternalities

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