Public Finance, Chapter 3
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Transcript of Public Finance, Chapter 3
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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.
3Instructed by YIN SOKHENG, Master in Finance
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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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.
5Instructed by YIN SOKHENG, Master in Finance
6Instructed by YIN SOKHENG, Master in Finance
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.
7Instructed by YIN SOKHENG, Master in Finance
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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* .
Instructed by YIN SOKHENG, Master in Finance
Figure 3.2 The Social Optimal Quantity of aPolluting Good
9Instructed by YIN SOKHENG, Master in Finance
P
$3.50
80 100
D (MB)
S (MPC)
MSC
Q
I
J
KH
gallons
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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
Instructed by YIN SOKHENG, Master in Finance
11
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
Instructed by YIN SOKHENG, Master in Finance
Figure 3.3 The Optimal Tax Equals the MarginalDamage
12Instructed by YIN SOKHENG, Master in Finance
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
Instructed by YIN SOKHENG, Master in Finance
Figure 3.4 The Net Benefit from the Optimal Tax
14Instructed by YIN SOKHENG, Master in Finance
P
$3.50
80 100
D (MB)
MSC
Q
I
J
KH
S (MPC)
15
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.
Instructed by YIN SOKHENG, Master in Finance
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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).
Instructed by YIN SOKHENG, Master in Finance
Figure 3.5 The Optimal Cutback of Pollution
17Instructed by YIN SOKHENG, Master in Finance
$100
$50
25 50
$200 MACH
T = MD = $40
Emissions
$40MD
$25$20
30 35 40 4510
MACL$60
18
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.
Instructed by YIN SOKHENG, Master in Finance
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Figure 3.6 The Permit Market
19Instructed by YIN SOKHENG, Master in Finance
$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
22Instructed by YIN SOKHENG, Master in Finance
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
Gift from the Government: L 45, H 45 permitsP L emits Ls gift L demands L supplies H emits Hs gift H demands H supplies
$20
$40
$60
The End
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Gift from the Government: L 5, H 45 permitsP L emits Ls gift L demands L supplies H emits Hs gift H demands H supplies
$20
$40
$60
Instructed by YIN SOKHENG, Master in Finance