HE191 Principles of Economics Lecture 4

Chapters 10, 11 and 12 Principles of Economics, Fourth Edition N. Gregory Mankiw

In this lecture, look for the answers to these questions:
What is an externality? Why do externalities make market outcomes inefficient? How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? What policies aim to solve the problem of externalities? What are public goods? What are common resources? Give examples of each. Why do markets generally fail to provide the efficient amounts of these goods? How might the government improve market outcomes in the case of public goods or common resources? What are the efficiency costs of taxes?

are usually a good way to organize economic activity.
Lesson from Lecture 3: Recall one of the Ten Principles from Lecture 1: Markets

In the absence of market failures, the competitive market outcome is efficient, maximizes total surplus.
One type of market failure: externalities. Externality: the uncompensated impact of one person’s actions on the well-being of a bystander Negative externality: the effect on bystanders is adverse Positive externality: the effect on bystanders is beneficial

Governments can sometimes improve market outcomes.

Pollution: A Negative Externality • Example of negative externality: Air pollution from a factory.
– The firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity.

• How govt may improve the market outcome:
– Impose a tax on the firm equal to the external cost of the pollution it generates

Recap of Welfare Economics: The market for gasoline
P $5
4 3 $2.50 2 1 0 0 10 Supply curve shows private cost, the costs directly incurred by sellers Demand curve shows private value, the value to buyers (the prices they are willing to pay) 20 25 30 Q (gallons) The market eq’m maximizes consumer + producer surplus.

Analysis of a Negative Externality: The market for gasoline
P $5
4 3 2 1 0 0 10 20 external cost

Social cost = private + external cost
Supply (private cost)

External cost = value of the negative impact on bystanders = $1 per gallon (value of harm from smog, greenhouse gases) 30 Q gallons

Analysis of a Negative Externality: The market for gasoline
P $5
4 3 2 D 1 0 0 10 Social cost
•The socially optimal quantity is 20 gallons. • At any Q < 20, value of additional gas exceeds social cost. •At any Q > 20, social cost of the last gallon is greater than its value. •Market eq’m (Q = 25) > social optimum (Q = 20) • One solution: tax sellers $1/gallon, would shift supply curve up $1. The tax is known as corrective tax.


20 25 30 Q (gallons)

“Internalizing the Externality”
Corrective tax: a tax designed to account for the social costs that arise from a negative externality Also called Pigouvian taxes after Arthur Pigou (1877-1959). Internalizing the externality: altering incentives so that people take account of the external effects of their actions In the previous example, the $1/gallon tax on sellers makes sellers’ costs equal to social costs. When market participants must pay social costs (private cost + tax), the market eq’m matches the social optimum.

Example of Positive Externality
A more educated population benefits society: lower crime rates: educated people have more opportunities, so less likely to rob and steal better government: educated people make better-informed voters People do not consider these external benefits when deciding how much education to “purchase” Result: market eq’m quantity of education too low How government may improve the market outcome: subsidize cost of education

A C T I V E L E A R N I N G 1: Analysis of a positive externality
P The market for flu shots
$50 40 30 20 10 0 0 10 20 30 S External benefit = $10/shot • Draw the social value curve. • Find the socially optimal Q. • What policy would internalize this externality?



A C T I V E L E A R N I N G 1: Answers
P The market for flu shots
$50 40 30 20 10 0 0 10 20 25 30 external benefit S

Socially optimal 25 shots Q = _____ To internalize the externality, use subsidy = $10/shot _____

Social value = private value + external benefit


Private Solution to Externalities
The Coase theorem: If private parties can bargain without cost over the allocation of resources, they can solve the externalities problem on their own. An Example: Dick owns a dog named Spot. Negative externality: Spot’s barking disturbs Jane, Dick’s neighbor. The socially efficient outcome: maximizes Dick’s + Jane’s well-being. If Dick values having Spot more than Jane values peace & quiet, the dog should stay.

Coase theorem: The private market will reach the efficient outcome on its own…

The Coase Theorem: An Example
Dick has the right to keep Spot.

Benefit to Dick of having Spot = $500 Cost to Jane of Spot’s barking = $800 Socially efficient outcome: Spot goes bye-bye. Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off. Private outcome = efficient outcome.

The Coase Theorem: An Example
Dick has the right to keep Spot.

Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800 Socially efficient outcome: See Spot stay. Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays. Private outcome = efficient outcome.

The Coase Theorem: An Example
CASE 3: Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800

But Jane has the legal right to peace & quiet.
Socially efficient outcome: Dick keeps Spot. Private outcome: Dick pays Jane $900 to put up with Spot’s barking. Private outcome = efficient outcome.
Surplus is 100$

The private market achieves the efficient outcome The private market achieves the efficient outcome regardless of the initial distribution of rights. regardless of the initial distribution of rights.

Why Private Solutions Do Not Always Work
Transaction costs: the costs that parties incur in the process of agreeing to and following through on a bargain Sometimes when a beneficial agreement is possible, each party may hold out for a better deal. Coordination problems & costs when the number of parties is very large.

Public Policies Toward Externalities
Two approaches Command-and-control policies regulate behavior directly. Examples:
limits on quantity of pollution emitted requirements that firms adopt a particular technology to reduce emissions Market-based policies provide incentives so that private decisionmakers will choose to solve the problem on their own.

Market-Based Policy #1: Corrective Taxes
Example: Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO2 causes acid rain & other health issues. Policy goal: reducing SO2 emissions 25% Policy options 1. Regulation: require each plant to cut emissions by 25% 2. Corrective tax: make each plant pay a tax on each ton of SO2 emissions. Set tax at level that achieves goal.

ACME SO2 emitted 40 tons $100/ton for cutting the first 10 tons. Costs rise by 10% for each additional 10 tons cut Cuts 10 tons of SO2 ___________
$100*10=1000 $

US Electric 40 tons $200/ton for cutting first 10 tons. Costs rise 10% for each additional 10 tons cut Cuts 10 tons of SO2 ___________
200*10 = 2000

Total cost

Firm's cost of reducing emission

Regulation to cut 25% Costs of SO2 reduction

3000 $


Tax of $111/ton of pollution up to a maximum of 20 tons Pays the tax instead of reducing pollution

Costs of SO2 reduction





Market-Based Policy #1: Corrective Taxes
The corrective tax is a price on the right to pollute. Under regulation, firms have no incentive to reduce emissions beyond the 25% target. Like other prices, the tax allocates the pollution to the firms who value it most highly (US Electric). A tax on emissions gives ACME the incentive to continue reducing emissions as long as the cost of doing so is less than the tax. If a cleaner technology becomes available, the tax gives firms an incentive to adopt it. In contrast with other taxes, corrective taxes enhance efficiency by aligning private with social incentives. Problem with tax: determining the amount of the tax.

Market-Based Policy #2: Tradable Pollution Permits
Issue 60 permits, each allows its bearer one ton of SO2 emissions (so total emissions = 60 tons) give 30 permits to each firm establish market for trading permits Each firm can choose among these options: emit 30 tons of SO2, using all its permits emit < 30 tons, sell unused permits buy additional permits so it can emit > 30 tons

ACME SO2 emitted Firm's cost of reducing emission Each firm has 30 permits with each permit allowing firm to pollute 1 ton of SO2 40 tons $100/ton for 1st 10 tons plus 10% for additional 10 tons ACME can sell the permit for at least $111 so cuts SO2 by 20 tons. It would have 10 permits to sell.

US Electric 40 tons $200/ton for the 1st 10 tons plus 10% for additional 10 tons Willing to buy 10 permits for $199/ton so it has the right to pollute 40 tons. Buys 10 permit for $1,500

Total cost

Suppose both Sells 10 permits and agree on price of earns $1,500 $150 Costs of SO2 reduction Net cost

____________ $600 $1,500


2100 $

Market-Based Policy #2: Tradable Pollution Permits
A system of tradable pollution permits achieves goal at lower cost than regulation. Firms with low cost of reducing pollution sell whatever permits they can. Firms with high cost of reducing pollution buy permits. Result: Pollution reduction is concentrated among those firms with lowest costs. Market decides the value of the pollution permit.

Public Goods and Common Goods
We consume many goods without paying: parks, national defense, clean air & water. When goods are free, the market forces that normally allocate resources are absent. The private market may fail to provide the socially efficient quantity of such goods. One of the Ten Principles from Chapter 1:

Governments can sometimes improve market outcomes.

Important Characteristics of Goods
A good is excludable if a person can be prevented from using it. excludable: fish tacos, dial-up internet service not excludable: FM radio signals, national

A good is rival in consumption if one person’s use of it diminishes others’ use. rival: fish tacos not rival:
An MP3 file of Coldplay’s latest hit song

The Different Kinds of Goods
Private goods: excludable, rival in consumption
example: food, clothing, shoes

Public goods: not excludable, not rival
example: national defense, uncongested parks

Common resources: rival but not excludable
example: fish in the ocean, common grazing land, forest

Natural monopolies: excludable but not rival
example: Telecom, cable TV, software, electric power etc

The Different Kinds of Goods
With public goods and common resources, externalities arise because something of value has no price attached to it. So, private decisions about consumption and production can lead to an inefficient outcome. Public policy can potentially raise economic well-being.

Common Resources
Common resources are not excludable. Additional problem with common resources: rival in consumption
Each person’s use reduces others’ ability to use which creates a tragedy of commons The tragedy is due to an externality: Allowing one’s flock to graze on the common land reduces its quality for other families. People neglect this external cost, resulting in overuse of the land.

Role for govt: ensuring they are not overused

Tragedy of commons
If there is one herder, cows<400 will graze land If there are 100 herders, each with 4 cows
q of each cow = 7 gal and each herder gets = 28 gal One herder grazes a 5th cow: q of each cow = 6.98 gal and he gets = 34.9 gal All herders graze a 5th cow: q of each cow = 5.4 gal and each herder gets = 27 gal
No. of Cows

Output Additional of Milk output per (gallons) cow

100 200 300 399 400 401 500 600

1000 2000 2600 2799 2800 2800 2700 2600
10 __


__ __ __
0 __

2 1




Policy Options to Prevent Overconsumption of Common Resources
Policy Options
Regulate use of the resource Impose a corrective tax to internalize the externality example: hunting & fishing licenses, entrance fees for congested national parks Auction off permits allowing use of the resource example: spectrum auctions by the U.S. Federal Communications Commission if the resource is land, convert to a private good by dividing and selling parcels to individuals

Public good
Will Lee, Tan and Lim pay for the maintenance of a park adjacent to their homes? Scenario
Lee, Tan and Lim own adjacent properties Their properties are adjacent to a park The cost of maintaining the park is $1,200 per month Lee earns twice as much as Tan and Tan earns twice as much as Lim Lee is willing to pay $800, Tan $400 and Lim $200 The benefit, $1,400 > than the cost, $1,200

NOTE: Demand for public goods are added vertically: $800 + $400 + $200 = $1,400

Public Goods
The Outcome
Sharing is efficient (Benefit > cost) Barriers to sharing the cost
Cost of negotiation Free rider: a person who receives the benefit of a good but avoids paying for it
If good is not excludable, people have incentive to be free riders, because firms cannot prevent non-payers from consuming the good.

Reluctance to share information makes measuring the benefits difficult

Public Goods
Cost-benefit analyses are imprecise, so the efficient provision of public goods is more difficult than that of private goods. Public goods are difficult for private markets to provide because of the free-rider problem. Result: The good is not produced, even if buyers collectively value the good higher than the cost of providing it.

Common Resources and Public goods: Conclusion
Public goods tend to be under-provided, while common resources tend to be over-consumed. These problems arise because property rights are not well-established: Nobody owns the air, so no one can charge polluters. Result: too much pollution. Nobody can charge people who benefit from national defense. Result: too little defense. The govt can potentially solve these problems with various policy options.

Government Provision of Public Goods and Tax
Will government maintain the park if there is an “equal tax” rule”? Assume
There is a “nondiscrimination” tax rule. A majority of the citizens must approve the provision of a public good.

The Outcome
A head tax or lump-sum tax will collect $400 each from Lee, Tan and Lim. Lim has a $200 reservation price, and will vote against it.

Government Provision of Public Goods and Tax
A lump-sum tax is a regressive tax.
Lump-sum Tax
A tax that collects the same amount from every taxpayer

Regressive Tax
A tax under which the proportion of income paid in taxes declines as income rises.

Government Provision of Public Goods and Tax
Example Will the government maintain the park if there is a proportional tax on income? Proportional Income Tax One under which all taxpayers pay the same proportion of their incomes in taxes With a proportional tax:
Lee pays $685.71; Tan pays $342.86 and Lim pays 171.43 All amounts are below their reservation prices. They would have a well-maintained park. Economic surplus would increase: Lee: $800 - $685.71 = $114.29 Tan: $400 - $342.86 = $57.14 Lim: $200 – 171.43 = $28.57 Total increase in surplus = $200

Taxes and Efficiency
One tax system is more efficient than another if it raises the same amount of revenue Equity vs Efficiency at a smaller cost to taxpayers. The costs to taxpayers include: the tax payment itself, deadweight losses and administrative burden Recall from Chapter 8: Taxes on private goods causes deadweight loss. The fall in taxpayers’ well-being exceeds the revenue the govt collects.

Administrative Burden
includes the time and money people spend to comply with tax laws encourages the expenditure of resources on legal tax avoidance e.g., hiring accountants to exploit “loopholes”
to reduce one’s tax burden

could be reduced if the tax code were simplified but would require removing loopholes (Note: Singapore’s tax administrative burden is lower than the United States)

Income vs. Consumption Tax
The income tax reduces the incentive to save:
If income tax rate = 25%, 8% interest rate = 6% after-tax interest rate The lost income compounds over time.

Some economists advocate taxing consumption instead of income.
would restore incentive to save better for individuals’ retirement income security and long-run economic growth Example: GST

Lump-Sum Taxes
A lump-sum tax is the same for every person Example: lump-sum tax = $4000/person A lump-sum tax is the most efficient tax: Most efficient but unfair

causes no deadweight loss

It does not alter equilibrium quantity and price of private goods

minimal administrative burden

no need to hire accountants, keep track of receipts, etc. Yet, not used because perceived as unfair: in dollar terms and relative to income, the poor pay as much as the rich In our example, Lim would be forced to pay for public goods more than he values such goods.

Taxes and Equity
Another goal of tax policy: equity – distributing the burden of taxes “fairly.” Agreeing on what is “fair” is much harder than agreeing on what is “efficient.” Yet, there are several principles people apply to evaluate the equity of a tax system.

The Benefits Principle
Benefits principle: the idea that people should pay taxes based on the benefits they receive from govt services Tries to make public goods similar to private goods – the more you use, the more you pay. Example: Gasoline taxes, in our example: making Lee, Tan and Lim pay for maintenance of the park

The Ability-To-Pay Principle
Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden recognizes that the magnitude of the sacrifice depends not just on the tax payment, but on the person’s income and other circumstances
a $10,000 tax bill is a bigger sacrifice for a poor person than a rich person Proportional tax in our example

Three Tax Systems
Proportional tax: taxpayers pay the same fraction of income Regressive tax: high-income taxpayers pay a smaller fraction of their income than low-income taxpayers (Lump sum tax) Progressive tax: high-income taxpayers pay a larger fraction of their income than low-income taxpayers

The Trade-Off Between Efficiency and Equity
The goals of efficiency and equity often conflict: E.g., lump-sum tax is the least equitable but most
efficient tax.

Political leaders differ in their views on this tradeoff. Economics
can help us better understand the tradeoff can help us avoid policies that sacrifice efficiency without any increase in equity

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