DFI 306

PUBLIC FINANCE
EXTERNALITIES
 EXTERNALITIES
• An output of an entity’s economic activity,
other than what was in indented to be output.
• The economic effect which occur from the
production or use of goods/services by other
economic units
• It is not a component the marketable product,
hence it is not price
• It affects a neighboring entities.
• The effect could be POSITIVE OR NEGATIVE
 Positive Externalities
• Is a beneficial externality, also called a merit
good, external benefit
• Examples
 Nature of Externalities
• Are produced by consumers as well as
producers
• Are Reciprocal in nature
• The effect of externalities is non-excludable
from consumption or production process
• Are non-priced (external to the pricing
system)
• Can be positive or Negative
 Positive Externalities
Merit good/External benefit /Economy

Main Activity Externality

• Bee keeping – Honey • Crop Cross Pollination
• Education-Trained • Society with no criminals
manpower
 Negative Externalities
(Social Cost/External Diseconomy)
Main Activity Externality
• Industrialization – get • Poisonous water (Rivers,
manufactured products Seas poisoning fish and then
people
Graphical Analysis
 Graphical Analysis cont
IMPLICATIONS
1.With externalities, private markets need not
produce the socially efficient output
2.Model shows how efficiency will be enhanced
by moving from ACTUAL OUTPUT to SOCIALLY
EFFICIENT OUTPUT.
3.The model provides a measure of the benefit
of switching to s. efficient point
 Graphical Analysis cont
4. Generally, zero pollution is not desirable
5. Finding the right amount of pollution
requires trading off its benefits and costs, the
optimum should occur at some level of
POSITIVE POLLUTION
6. Implementing framework requires an in-
depth analysis of approximate costs and
benefits
RESPONSES TO NEGATIVE
EXTERNALITIES
1. Private Responses
2. Public Responses
 Private Responses
a) Bargaining and Coase Theorem - After Ronald
Coase (1960), and Conda (1995) agues that
assigning property rights would solve the
problem of environmental pollution. “in England
and Scotland, rivers and highways are assigned
to private individuals hence overfishing and
pollution are controlled
b) Mergers
c) Social Conventions
d) Civil Tort
 Public Responses
a) Taxes – Pigovian Taxes
b) Subsidies – Pigovian Subsidies
c) Emission Fee
d) Cap-and-Trade
e) Command-and-Control Regulation
f) Criminalization
 a) Taxes – Pigovian Taxes
• This is a tax imposed upon the private
producer that is equal in value to the negative
externality
• Introduced by a British Economist A.C, Piqou
in 1930 upon industrialists who were polluting
the environment
• The tax reduces the amount of distortionary
taxes on the economy
 a) Taxes – Pigovian Taxes cont.
• Effect of tax:
• 1) Raises marginal cost of production (MPC)
by t from MPC to MPC+t
• ii) private producer then produces at MPC+t =
MB
• Iii) the government receives revenue
equivalent to the shaded part which the
increases public utility
b) Subsidies-Pigovian Subsidy
 b) Subsidies-Pigovian Subsidy
• This is a subsidy system where the producer is
compensated the would be lost profits
• This causes him/her to produce at the efficient
point where MB = MPC + subsidy ( which is
optimal Q*
 c) Emission Fees
• It is an “incentive Based Regulation” since it
provides market incentive to reduce pollution
• This is a Pigovian tax on levied on each unit of
negative externality emitted, hence, EMISSION
FEE
• This creates a market for pollution reduction
• The producer’s tax bill is reduced by a fee (f*)
reducing pollutants or charged the same fee for
such emission
 Pollution Reduction Market
Shs

MC

f*

MSB

e*
 d) Cap-and-Trade
• It is an “incentive Based Regulation” since it
provides market incentive to reduce pollution
• Is a government policy that grants permits to
producers who pollute environment by their
production process, thereby setting the desired
level of pollution.
• The policy allows polluters to trade their
permits amongst themselves at a cost effective
rates
e) Command-and-Control Regulation
• This is a government measure to regulate
pollution by way of:
1. Technology Standard-
Requires producers to install and use a
defined technology that is essential in
managing pollution
2.Performance Standard
. A regulation sets emission goal for each