Economics 1 Notes Externalities 2 A case for public intervention? In previous lessons government intervention has had undesirable side eects: { Sales

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1 Economics 1 Notes Externalities 1 Experiment 6{Negative Externalities

2 Economics 1 Notes Externalities 2 A case for public intervention? In previous lessons government intervention has had undesirable side eects: { Sales taxes caused excess burden. { Criminalization of drug use penalized addicts without curing addiction. { Minimum wage caused unemployment. { Price ceilings caused shortages. In the case of negative externalities, like pollution or trac we will see that the case for government congestion, intervention is much stronger.

3 Economics 1 Notes Externalities 3 Dealing with Externalities When there are negative externalities, competitive trading leads to inecient outcomes. It may not be ecient to eliminate negative externalities entirely. A sales tax on polluters can improve eciency when there are negative externalities { This contrasts with the \excess burden" of a sales tax when there are no externalities. Pollution can also be eciently regulated by issuing a xed supply of marketable premits.

4 Economics 1 Notes Externalities 4 Example: Number and Types of Agents Seller's Number in Buyer's Number Costs Market Value in Market

5 Economics 1 Notes Externalities 5 Externalities and a Sales Tax Price of Lawn Ornaments Number of Lawn Ornaments

6 Economics 1 Notes Externalities 6 Prots in Example Market Not counting externalities, total prots of buyers and sellers in market is $111. (Area between Supply and Demand this Curves to left of equilibrium quantity.) In this example, each unit sold costs $0.40 damage to each of the 50 participants. Since 20 units are sold, each person suers $0:40 20 = $8:00 pollution damage. Market has 50 people. Total pollution damage is 50 $8 = $200. Total prots net of pollution damage is $111, $200 =,$89.

7 Economics 1 Notes Externalities 7 Externalities in Example Market Prot-maximizers take into account the eects of their actions on their own prots and not the eects on others. only Every unit sold caused $.40 damage to each of 50 people. Thus somebody sells a lawn ornament, she does $20 worth of when damage in total. If total pollution damage per unit exceeds prot made by buyer and seller, the sale lowers total prot of group. Maximizing total prots of people in the room would require the only trades made would be those that give at least $20 that in total prots to buyer and seller. Competitive trading results in too many trades in this case.

8 We have seen that total from the industry, counting prots are negative. So total prots would be higher if externalities Economics 1 Notes Externalities 8 Shutting 'em Down this industry was shut down; In competitive equilibrium, price is $23 and each person suers $8 pollution damage. Question: If a vote was held and people voted selshly, which suppliers and demanders would: { vote to shut the industry down? { vote not to shut it down? What would the outcome be?

9 Economics 1 Notes Externalities 9 Sales Tax on Polluters Suppose that instead of shutting the industry down, the decided to reduce its output by means of a sales government tax. If the tax is as large as the total amount of damage done by a then sales will occur only when dierence between Buyer sale, Value and Seller Cost exceeds damage from sale. If each unit sold does $20 damage and is taxed at $20, the tax will be exactly enough to pay for the pollution damage revenue caused by the sale.

10 Economics 1 Notes Externalities 10 Externalities and a Sales Tax Price of Lawn Ornaments Number of Lawn Ornaments

11 Economics 1 Notes Externalities 11 Eects of the Sales Tax Supply Curve Shifts up by $20. Number of units sold is reduced from 20 to 12. Price rises from $23 to somewhere between $33 and $35. Government collects revenue of $20 12 = $240. Government returns equal shares of its revenue to all. Each gets $24 50 = $4:80 rebate from government. This rebate exactly equals the pollution damage inicted on each person, which was $0:40 12 = $4:80.

12 of the equilibrium quantity. This amount is left = $84: $4 Economics 1 Notes Externalities 12 Eect of Tax on Total Prots Total prots not counting pollution damage or tax rebates are to the area between the supply and demand curve to the equal From this we subtract total pollution damage and add total of government revenue (which is rebated to amount participants.) Note that total rebates ($240) equal total pollution damage since each unit produced is taxed at exactly the amount ($240) of damage it causes. Total prots of all demanders and suppliers when the pollution tax is imposed is therefore $84, $240 + $240 = $84.

13 prot that they would make if the industry were shut same and more than they would make if there was no gov't down of about $1, the 4 suppliers with SC of $8 make prots prots about $6 each and the 4 suppliers with SC of $4 make prots of Economics 1 Notes Externalities 13 More on Prots and the Tax Total prots ($84) with pollution tax are higher than with no intervention (-$89) or with industry shut down ($0). gov't With the tax, 12 demanders with BV's < $35 and 14 suppliers SC's > $13 do not trade and make $0 prots. This is the with intervention. With the tax, the 8 demanders with BV's of $40 make prots about $6 each, the 4 demanders with BV's of $35 make of of about $1 each.

14 Economics 1 Notes Externalities 14 The tax is better for some and at least as good for everybody as the outcome where the industry is shut down.

15 Economics 1 Notes Externalities 15 Externalities and Politics With negative externalities, the sum of the prots of all are higher with an optimal pollution tax than with participants no intervention. Does this mean that everyone will be in favor of such a tax? Not necessarily. In our example, with no intervention, the prots of a demander $40 BV is $40, $23, $8 = $9: With the pollution tax, his with prot is about $6. Also, the prots of the $35 BV demand and the prots of the and $13 SC sellers are higher with no intervention than with $8 the tax.

16 vote is close. 26 in favor, 24 against. In a realistic political but these individuals might win a legislative majority environment, Economics 1 Notes Externalities 16 In a political environment, these individuals will vote against tax. In our example, they would lose in majority voting, the through campaign contributions.