4 chapter externalities public sector economics: the role of government in the american economy...
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4CHAPTER
Externalities
PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Negative Externalities in Negative Externalities in Supply and Demand Supply and Demand
FrameworkFramework
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Corrective Taxation of an Corrective Taxation of an ExternalityExternality
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Taxation versus Taxation versus RegulationRegulation
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Positive ExternalitiesPositive Externalities
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
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
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Negative Inframarginal Negative Inframarginal ExternalitiesExternalities
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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe
Positive Inframarginal Positive Inframarginal ExternalitiesExternalities
Optimal quantity produced without Optimal quantity produced without subsidysubsidy
Example:Example: K-12 Education K-12 Education