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Office Hours: Monday 3:00-4:00 – LUMS C85

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1 Office Hours: Monday 3:00-4:00 – LUMS C85
ECON 101 Tutorial: Week 13 Shane Murphy Office Hours: Monday 3:00-4:00 – LUMS C85

2 Outline Roll Call Problems Notes about macroeconomics

3 Chapter 11: Problem 1 Do you believe in the following statements? Why or why not? The benefits of Pigouvian taxes as a way to reduce pollution have to be weighed against the deadweight losses that these taxes cause. In fact, Pigovian taxes reduce the inefficiency of pollution by reducing the quantity of the good being produced that has pollution as a by-product. So, Pigovian taxes reduce deadweight loss, they do not increase it. When deciding whether to levy a Pigovian tax on consumers or producers, the government should be careful to levy the tax on the side of the market generating the externality. It does not matter on whom the tax is imposed, the incidence of the tax will be identical (see chapter 6). So whether the externality is caused by the seller or the buyer of a good, a tax on either producers or consumers will lead to the same reduction of quantity and change in the prices producers receive or consumers pay.

4 Chapter 11: Problem 2 Consider the market for fire extinguishers.
Why might fire extinguishers exhibit positive externalities? Draw a graph of the market for fire extinguishers. Indicate the market equilibrium and efficient output. Why do these differ? Fire extinguishers exhibit positive externalities because even though people buy them for their own use, they may prevent fire from damaging the property of others. The market equilibrium and efficient output quantities differ because in deciding to buy fire extinguishers, people don't account for the benefits they provide to other people. If the external benefit is 10 per extinguisher, describe a government policy that would result in an efficient outcome. Subsidize people €10 for every fire extinguisher they buy

5 Chapter 11: Problem 3 In many countries, contributions to charitable organizations are deductible from income tax. In what way does this government policy encourage private solutions to externalities. Charitable organizations are often organized to deal with externalities. By allowing charitable contributions to be made from pre-tax income, the government raises charities’ incomes above what they would otherwise be, thus encouraging private solutions to the externality. People can give to the organization that they feel provides the most benefit to society, so the tax relief may be more effective than if the government itself tried to solve the externality. For example, local community groups may be better at helping the needy than government welfare programs.

6 Chapter 11: Problem 4 It is rumored that the Swiss government subsidizes cattle farming, and that the subsidy is larger in areas with more tourist attractions. Can you think of a reason why this policy might be efficient? If the Swiss government subsidizes cattle farming, it could be because there are externalities associated with it. Since tourists come to Switzerland to see the beautiful countryside, encouraging farms, as opposed to industrial development, is important to maintaining the tourist industry. Thus farms produce a positive externality by keeping the land beautiful and unspoiled by development. The government's subsidy thus helps the market provide the optimal amount of farms.

7 Chapter 11: Problem 5 Consider the market for train travel. At certain times of the day, trains are extremely crowded going to major towns and cities but at other times of the day carriages are virtually empty. Is this an example of market failure? What externalities exist on the train system if the situation described persists? Can you think of a way in which the government might step in to make the market outcome more efficient? Both an over use and underuse of trains during any day can be seen as market failure. For example, every time an individual chooses to travel by train during the rush hour, he or she is imposing external costs on other people who have to stand. Therefore main negative externality is that trains are so overcrowded at peak times that customers have to stand. However there are also some positive externalities associated with train travel. More people using trains make roads less congested. Trains are also safer than road travel and less polluting per passenger mile. The government could subsidise off peak travel to encourage more users. It could tax peak travel to attempt to reduce demand, but private rail companies already have high peak fares when people have little choice over their travel arrangements. In the long term the government could give train companies grants to invest in a new infrastructure, because in general, train transportation has significant positive externalities and so it can be argued that it is under supplied by the private sector.

8 Chapter 11: Problem 6 Greater consumption of alcohol leads to more motor vehicle accidents and, thus, imposes costs on people who do not drink and drive. Illustrate the market for alcohol. a. The market for alcohol is shown. The social value curve is below the demand curve because of the negative externality from increased motor vehicle accidents caused by those who drink and drive. The free-market equilibrium level of output is Qmarket and the efficient level of output is Qoptimum. b. The triangular area between points A, B, and C represents the deadweight loss of the market equilibrium. This area shows the amount by which social costs exceed social value for the quantity of alcohol consumption beyond the efficient level.

9 Chapter 11: Problem 7 Many observers believe that the levels of pollution in our economy are too high. If society wishes to reduce overall pollution by a certain amount, why is it efficient to have different amounts of reduction at different firms? It is efficient to have different amounts of pollution reduction at different firms because the cost of reducing pollution differs across firms. If they were all made to reduce pollution by the same amount, the costs would be low at some firms and prohibitive at others, imposing a greater burden overall.

10 Chapter 11: Problem 7 Command-and-control approaches often rely on uniform reductions amoung firms. Why are these approaches generally unable to target the firms that should undertake bigger reductions? Command-and-control approaches usually rely on uniform pollution reduction among firms because government regulators do not have sufficiently detailed knowledge of firms’ costs and technologies to enable them to target reductions on the firms that would be able reduce pollution most cheaply.

11 Chapter 11: Problem 7 Economists argue that appropriate Pigovian taxes or tradable pollution rights will result in efficient pollution reduction. How do these approaches target the firms that should undertake bigger reductions? Pigovian taxes or tradable pollution rights give firms greater incentives to reduce pollution. Firms that find it relatively easy to reduce pollution have an on-going incentive to reduce pollution and they are likely to reduce pollution by more than might be required by command-and-control regulations. By doing so they avoid tax or enable themselves to sell pollution permits they don’t need to other firms. Firms that find it very costly to reduce pollution will continue to pollute and pay the tax or buy more pollution permits. The government does not have to work out which firms can reduce pollution the most cheaply – the tax and tradable permits approaches both let the market decide which firms should reduce pollution.

12 Chapter 11: Problem 8 The Pristine River (or the Blue Pristine, as it is affectionately known) has two polluting firms on its banks. European Industrial and Creative Chemicals each dump 100 tonnes of effluent into the river each year. The cost of reducing effluent emissions per tonne equals €10 for European Industrial and €100 for Creative. The government wants to reduce overall pollution from 200 tonnes to 50 tonnes per year. If the government knew the cost of reduction for each firm, what reductions would it impose to reach its overall goal? What would be the cost to each firm and the total cost to the firms together? If the government knew the cost of reduction at each firm, it would have European Industrial eliminate all its pollution (at a cost of €10 per tonne times 100 tonnes = €1,000) and have Creative eliminate half of its pollution (at a cost of €100 per tonne times 50 tonnes = €5,000). This minimizes the total cost (€6,000) of reducing pollution to 50 tonnes.

13 Chapter 11: Problem 8 In a more typical situation, the government would not know the cost of pollution reduction at each firm. If the government decided to reach its overall goal by imposing uniform reductions on the firms. Calculate the reduction made by each firm, the cost to each firm and the total cost to the firms together. If each firm had to reduce pollution to 25 tonnes (so each had to reduce pollution by 75 tonnes), the cost to European Industrial would be 75 x €10 = €750 and the cost to Creative would be 75 x €100 = €7,500. The total cost would be €8,250.

14 Chapter 11: Problem 8 Compare the total cost of pollution reduction in parts a and b. If the government does not know the cost of reduction for each firm, is there still some way to reduce pollution to 50 tonnes at the total cost you calculated in part a? In part a, it costs €6,000 to reduce total pollution to 50 tonnes, but in part b it costs €8,250. So it is definitely less costly to have European Industrial reduce all of its pollution and have Creative cut its pollution in half. Even without knowing the costs of pollution reduction, the government could achieve the same result by auctioning off pollution permits that would allow only 50 tonnes of pollution. This would ensure that European Industrial reduced its pollution to zero (since Creative would outbid it for the permits) and Creative would then reduce its pollution to 50 tonnes. Assume that the chief executive officers of the firms have considerable influence with politicians. How might market outcome be influenced as a consequence?

15 Chapter 11: Problem 9 Suppose that the government decides to issue tradable permits for a certain form of pollution. Does it matter for economic efficiency whether the government distributes or auctions the permits? Does it matter in any other ways? In terms of economic efficiency in the market for pollution, it does not matter if the government simply distributes the permits to polluters free of charge or auctions them off, as long as firms can sell the permits to each other. The only difference would be that the government could make money if it auctioned the permits off, thus allowing it to reduce taxes, which would help reduce the deadweight loss from taxation. There could also be some deadweight loss occurring if firms use resources to lobby for additional permits.

16 Chapter 11: Problem 9 Suppose that the government decides to issue tradable permits for a certain form of pollution. If the government chooses to distribute the permits, does the allocation of permits among firms matter for efficiency? Does it matter in any other way? If the government allocated the permits to firms who did not value them as highly as other firms, the firms could sell the permits to each other so they would end up in the hands of the firms who value them most highly. Thus the allocation of permits among firms would not matter for efficiency. But it would affect the distribution of wealth, since those who got the permits and sold them would be better off.

17 Chapter 11: Problem 10 Some people argue that the primary cause of global warming is carbon dioxide, which enters the atmosphere in varying amounts from different countries but is distributed equally around the globe within a year. In order to solve this problem, some economists have argued that carbon dioxide emissions should be reduced in countries where the costs are least, with the countries that bear that burden being compensated by the rest of the world. Why is international cooperation necessary to reach an efficient outcome? International cooperation is needed because the externality from global warming is worldwide, so the benefits from solving the problem are worldwide. Further, the efficient solution to the problem involves minimizing the costs to society; in this case, society means the entire world.

18 Chapter 11: Problem 10 Is it possible to devise a compensation scheme such that all countries would be better off than under a system of uniform emission reductions? Explain. Since it would be efficient to reduce carbon dioxide most in countries where the costs of reducing carbon dioxide emissions are low, some compensation scheme needs to be put in place to encourage the reduction of emissions. One possibility would be to monitor emissions, taxing those countries whose emissions are high and using the proceeds to subsidize those who reduce their emissions. This gives the incentive to reduce emissions in those areas where the cost of doing so is the least. In countries where the cost of reducing emissions is high, they will just pay the tax. A system of uniform emission reductions would impose high costs on some countries and low costs on others, and would not give anyone the incentive to reduce emissions beyond the compulsory amount.

19 A word about macroeconomics
Deep down, macroeconomics is about growth and inequality We want to maximize growth We want to minimize inequality The UK government can do this by getting things right: Tax rates Interest rates, inflation, and money supply Unemployment and government spending

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