public finance, chapter 3

7/31/2019 Public Finance, Chapter 3

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Chapter 3

Externalities and

the Environment

Prepared and Taught by

Lecturer: YIN SOKHENG, Master in Finance

2Instructed by YIN SOKHENG, Master in Finance

Externality Defined

An externality is present when the activity ofone entity (person or firm) directly affects thewelfare of another entity in a way that isoutside the market mechanism.

Negative externality: These activitiesimpose damages on others.

Positive externality: These activities

benefits on others.


Examples of Externalities Negative Externalities

Pollution

Cell phones in a movietheater

Congestion on theinternet

Drinking and driving

Student cheating thatchanges the grade curve

Positive Externalities

Research & development Vaccinations

A neighbors nice

landscape

Students asking goodquestions in class

NotConsidered Externalities

Land prices rising in urbanarea

Known as pecuniary

externalities


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4

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 atax and by a permit price.

Tax method: The govt. sets a tax per unit of pollutantX.

Permit method: The govt. decides the aggregatequantity of pollutant X it is willing to tolerate.



B

C

D

Output Q

Figure 3.1 The Trade-Off between Output andEnvironmental Quality

E

F

A

B

C

D

E

F

A

Environmentalquality


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Pollution Tax Analysis

For example: A competitive market is governedby 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 quantityactually bought and sold will be 100 gallons.


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Graphical Analysis MB = marginal benefit to the firm

MPC = marginal privatecost to the firm

MD = marginal damage to theenvironment

MSC = MPC+MD = marginal socialcost

The firm maximizes profits at MB=MPC.This quantity is denoted as Q1.

Social welfare (socially optimal) is

maximized at MB=MSC, which is denotedas Q* .


Figure 3.2 The Social Optimal Quantity of aPolluting Good


P

$3.50

80 100

D (MB)

S (MPC)

MSC

Q

I

J

KH

gallons


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10

Graphical AnalysisFigure 3.2

MB = MPC : Optimal Quantity 100 units=The firm maximizes profits

MD = $1

MSC = MPC+MD: marginal socialcost

MB = MSC: Social welfare (socially optimalQuantity) is maximized at 80 units


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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 toshift up the supply curve by $1 because thetax would increase the marginal private costseller have to pay by $1.

If T = MD, the reduction in the polluting goodfrom 100 to 80 units confers a net benefit

on society. Gross benefit, HIJK = $1 x 20 = $20


Figure 3.3 The Optimal Tax Equals the MarginalDamage


P

$3.50

80 100

D (MB)

S (MPC)

Q

I

J

KH

S (MPC)


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Graphical Analysis,

The Net Benefit from the Optimal Tax

Figure 3.4

If the environmental benefit were not

counted, the cutback would impose a lossthe economy; that loss would equal the areaHIK.

The losses over all units cut gives the areaHIK; the area of HIK = ($1 x 20) = $10

Hence the net benefit to society of thecutback equal the area IJK = HIJK HIK =$20 $10 = $10


Figure 3.4 The Net Benefit from the Optimal Tax


P

$3.50

80 100

D (MB)

MSC

Q

I

J

KH

S (MPC)

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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 peremission should be levied on all firmsemitting pollution X.

If the government sets the tax T equal to themarginal damage MD, what the firms thendo for profit will unintentionally be what isbest for society.



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Graphical AnalysisFigure 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 MACLrises slowly.

MD = $40 per emissions

For each firm, staring from an emissionslevel of 50, each unit abate entails a highermarginal abatement cost (MAC).


Figure 3.5 The Optimal Cutback of Pollution


$100

$50

25 50

$200 MACH

T = MD = $40

Emissions

$40MD

$25$20

30 35 40 4510

MACL$60

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Trade Permits (permit market)

Instead of levying a tax, suppose thegovernment requires firms to have a permit foreach unit of pollution that it emits.

Figure 3.6; as shown, the governmentdecided to supply 50 permits.

The government would adjust its tentativeprice until it arrives at a final price of $40.



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Figure 3.6 The Permit Market


$50

50

$200 DH

Permits

$40

S

$20

30 35 40 4510

DL$60

75

D

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

$40.20Instructed by YIN SOKHENG, Master in Finance

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.



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Table 3.1 Demand for Extra Permits and Supply of

Excess Permits


Gift from the Government: L 25, H 25 permitsP L emits Ls gift L demands L supplies H emits Hs gift H demands H supplies

$20 30 25 5 0 45 25 20 0

$40 10 25 0 15 40 25 15 0

$60 0 25 0 25 35 25 10 0


$20

$40

$60

The End

23


$20

$40

$60


public finance, chapter 3

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