2. Definition of an Externality
Economic cost/benefit that is the by-product of economic activity
Allocated outside of market system
There are both negative and positive externalities

3. Public Policy Toward Externalities
Importance of transactions costs
Large numbers = High transactions
High transactions costs make bargaining break down
Importance of internalization of externalities

4. Negative Externalities
Cost imposed on others as by-product of productive activity
Allocated outside of market system
Market price understates true opportunity cost of production
Example: pollution

5. Negative Externalities in Supply and Demand Framework

6. Private Actions to Correct an Externality
Small numbers – private exchange may allow for internalization of externality
Example: Leaf burning neighbor

7. Corrective Taxation of an Externality
Charge a tax equal to external cost
results in economically efficient level of output
Difficult to estimate total external cost
Difficult to determine who is responsible for cost

8. Corrective Taxation of an Externality

9. What Should be Taxed? Can reduce external cost in other ways
Example: smokestack scrubber
Create incentives to reduce amount of externality per unit of production
Set tax equal to cost externality imposes on others

10. Should Compensation be Paid to Those Harmed?
Reciprocal nature of problem
Proceeds of corrective tax should not be paid as compensation
Gives both parties incentive to avoid harm

11. Taxation versus Regulation
Regulation – requires certain steps be taken to reduce externality
Taxes and regulations – same effects in short run
Reduce output
Different effects in long run
Regulation creates profits, encourages entry
Optimal tax creates losses, encourages exit

12. Taxation versus Regulation

13. Politics of Quotas versus Taxes
Firms - regulatory solutions more profitable than corrective taxes
firms will lobby for regulatory solutions
Taxpayers - benefit from corrective taxes
Corrective taxes generate additional revenue
Does not provide long-run incentive for entry
Firms usually have more political influence

14. Incentives for Regulation versus Taxation
Regulatory solution – approximates corrective tax solution in short run
Does not give incentive to further reduce externality
Corrective tax solution – gives incentive to reduce externality when cost effective
Difficult to apply in real world
Negative political pressure

15. Marketable Pollution Rights
Can help allocate resources more efficiently
Can reduce pollution over time without excess burden
Less political opposition

16. Marketable Pollution Rights
Established by giving firms rights to create certain amount of pollution
Rights can be bought and sold
Buy rights to increase pollution
Sell rights when pollution reduced
Example: Clean Air Act of 1990

17. Politics and Pollution Control
Corrective taxes and regulation
Impose costs on existing polluters
Create opposition
Marketable rights
Imposes no additional costs
Incentive to reduce pollution

18. Optimal Amount of Pollution
Weigh marginal benefits against marginal costs
Zero pollution is not optimal
Negative externalities cited as reason for government involvement in economy

19. Positive Externalities
Benefit to others not allocated within market
Demand curve does not reflect true value of activity
Activity will be under-produced

20. Positive Externalities

21. Solutions
Subsidies – negative taxes that correct for positive used externalities
Optimal subsidy set equal to amount of external benefit

22. Excess Burden and Excess Benefit
Should we subsidize all positive externalities?
Should we tax all negative externalities?
Excess burden of taxation needs to be considered

23. Technological and Pecuniary Externalities
Technological externalities – directly affect firm’s production function or individuals utility function
Operate outside market system

24. Technological and Pecuniary Externalities
Pecuniary externalities – influence market supply and demand conditions
No resources allocated outside market system
Does not result in misallocation of resources
Government involvement can cause resource misallocation

25. Marginal and Inframarginal Externalities
Inframarginal externalities – no marginal benefits/costs
Individuals account for benefits/costs of actions at the margin
Do not necessarily imply inefficient allocation of resources
Do not require policy action

26. Negative Inframarginal Externalities
A marginal reduction in externality will not make anyone better off
Optimal tax is zero

27. Negative Inframarginal Externalities

28. Positive Inframarginal Externalities
Optimal quantity produced without subsidy
Example: K-12 Education

29. Positive Inframarginal Externalities