CHAPTER

4
Externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Definition of an Externality
Economic

cost/benefit that is the byproduct of economic activity

Allocated outside of market system
There are both negative and positive
externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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Public Policy Toward

Externalities
Importance

of transactions costs

Large

numbers = High transactions

High transactions costs make bargaining
break down
Importance

of internalization of
externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-4

Negative Externalities in Supply

and Demand Framework

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-5

Private Actions to Correct an

Externality
Small

numbers private exchange may

allow for internalization of externality
Example: Leaf burning neighbor

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-6

Corrective Taxation of an
Externality
Charge

a tax equal to external cost

results

output

in economically efficient level of

Difficult

to estimate total external cost

Difficult to determine who is responsible
for cost

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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Corrective Taxation of an
Externality

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-8

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-9

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-10

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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

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Taxation versus Regulation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-12

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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

4-13

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
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

4-14

Marketable Pollution Rights

Can

help allocate resources more

efficiently
Can reduce pollution over time without
excess burden
Less political opposition

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-15

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-16

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-17

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-18

Positive Externalities
Benefit

to others not allocated within

market
Demand curve does not reflect true value
of activity
Activity will be under-produced

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-19

Positive Externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-20

Solutions
Subsidies

negative taxes that correct for

positive used externalities
Optimal subsidy set equal to amount of
external benefit

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-21

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-22

Technological and Pecuniary

Externalities
Technological

externalities directly
affect firms production function or
individuals utility function
Operate outside market system

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-24

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-25

Negative Inframarginal
Externalities
A marginal

reduction in externality will

not make anyone better off
Optimal tax is zero

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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Negative Inframarginal
Externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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Positive Inframarginal
Externalities
Optimal

quantity produced without

subsidy
Example: K-12 Education

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

4-28

Positive Inframarginal
Externalities

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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