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
– 3- Corrective subsidies
– 4- Property rights and Coase Theorem
– 5- Efficient abatement level
– 6- Regulatory solutions
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
• 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
MSC = MPC + MEC
Price, Benefit, and Cost (Dollars)
Figure 3.1 Market Equilibrium, A Negative Externality and
Efficiency
MPC + MEC = MSC
110
105
100
G
B
10
S = MPC
10
A
D = MSB
4.5 5
Tons of Paper Per Year (Millions)
Implications of Figure 3.1
• Market equilibrium occurs
where
MPC = MSB
• Efficiency Requires that
MSC = MPC + MEC = MSB
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
MSB = MPB + MEB
Price, Benefit, and Cost (Dollars)
Figure 3.2 Market Equilibrium, A Positive Externality and
Efficiency
45
Z
30
25
10
S = MSC
V
U
H
MPB + MEB = MSB
0
10 12
Inoculations Per
Year (Millions)
Price, Benefit, and Cost (Dollars)
Figure 3.3 A Positive Externality for Which MEB Declines With
Annual Output
MPBi + MEB = MSB
30
25
F
A
S = MSC
B
20
0
MPBi
10 12
16
20
Inoculations per Year (Millions)
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
• Setting a tax equal to the
MEC will internalize a negative
externality.
Price, Benefit, and Cost (Dollars)
Figure 3.4 A Corrective Tax
S’ = MPC + T = MSC
S = MPC
G
110
105
100
95
B
Tax Revenue = Total
External Costs
T
A
Net Gains in
Well-Being
D = MSB
4.5 5
Tons of Paper Per Year (Millions)
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
• 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
–A polluting Monopolist
• A dillema
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 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
MPC + MEC = MSC
F
MPC
A
Price
PM
B
C
D = MSB
MR
0
QM Q*
Output per Year
3- Corrective Subsidies
• Setting a subsidy equal to MEB will
internalize a positive externality
• For example:
– Garbage collection, tree plantation
Price, Benefit, and Cost (Dollars)
Figure 3.6 A Corrective Subsidy
Z
45
30
25
R
S = MSC
V
U
Subsidy Payments
10
Y
X
D' = MPB i+ $20 = MSB
D = MPB i
0
10 12
Inoculations per Year (Millions)