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Public Finance, Chapter 3

Public Finance, Chapter 3

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Published by YIN SOKHENG
Public Finance prepared by Lecturer Yin Sokheng, Master in Finance
www.accviw.blogspot.com
Public Finance prepared by Lecturer Yin Sokheng, Master in Finance
www.accviw.blogspot.com

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Categories:Business/Law, Finance
Published by: YIN SOKHENG on Sep 06, 2012
Copyright:Attribution Non-commercial

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04/18/2014

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1
Chapter 3
Externalities andthe Environment
Prepared and Taught byLecturer: YIN SOKHENG, Master in Finance
2
 Instructed by YIN SOKHENG, Master in Finance
Externality Defined
 An externality is present when the activity of one entity (person or firm) directly affects thewelfare of another entity in a way that isoutside the market mechanism.
 –
Negative externality 
: These activitiesimpose damages on others.
 –
Positive externality 
: These activitiesbenefits on others.
 
3
 Instructed by YIN SOKHENG, Master in Finance
Examples of Externalities
Negative Externalities
 –
Pollution
 –
Cell phones in a movietheater
 –
Congestion on theinternet
 –
Drinking and driving
 –
Student cheating thatchanges the grade curve
Positive Externalities
 –
Research & development
 –
Vaccinations
 –
A neighbor’s nice
landscape
 –
Students asking goodquestions in class
Not 
Considered Externalities
 –
Land prices rising in urbanarea
 –
Known as “pecuniary”
externalities
 
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4
Nature of Externalities
Arise because there is no market price attached tothe activity
Can be produced by people or firms
Can be positive or negative
Public goods are special case
 –
Positive externality’s full effects are felt by everyone in the
economy
 Instructed by YIN SOKHENG, Master in Finance
The Economist’s Approach to
Pollution
The govt. charge polluters a price in order todiscourage pollution.
The govt. can charge a price in two way: by atax and by a permit price.
Tax method: The govt. sets a tax per unit of pollutantX.
Permit method: The govt. decides the aggregatequantity of pollutant X it is willing to tolerate.
5
 Instructed by YIN SOKHENG, Master in Finance
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 Instructed by YIN SOKHENG, Master in Finance
BDOutput Q
Figure 3.1 The Trade-Off between Output andEnvironmental Quality
 ABD A
   E   n   v   i   r   o   n   m   e   n   t   a    l   q   u   a    l   i   t   y
 
3
Pollution Tax Analysis
For example: A competitive market is governedby demand and supply, as shown for gasoline inFigure 3.2.
The market will go to the intersection point: The priceof gasoline will turn out to be $3.50, and the quantityactually bought and sold will be 100 gallons.
7
 Instructed by YIN SOKHENG, Master in Finance
8
Graphical Analysis
MB = marginal benefit to the firm
MPC = marginal
private 
cost to the firm
MD = marginal damage to theenvironment
MSC = MPC+MD = marginal
social 
cost
The firm maximizes profits at
MB=MPC 
.This quantity is denoted as Q
1.
Social welfare (socially optimal) ismaximized at
MB=MSC 
, which is denotedas Q
*
.
 
 Instructed by YIN SOKHENG, Master in Finance
Figure 3.2 The Social Optimal Quantity of aPolluting Good
9
 Instructed by YIN SOKHENG, Master in Finance
P$3.5080 100D (MB)S (MPC)MSC QI JHgallons

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