Public Finance: Public

Expenditure
Externalities and Public Policy
Externalities

 Externalities
are costs or benefits of
market transactions not reflected in
prices.
 Negative externalities are costs to third
parties.
 Positive externalities are benefits to
third parties .
Externalities and Efficiency

The marginal external cost is the

dollar value of the cost to third
parties from the production or
consumption of an additional unit of
a good. This occurs when there is a
negative externality.
Social Costs

MSC = MPC + MEC

Figure 3.1 Market Equilibrium, A Negative
Externality and Efficiency
Price, Benefit, and Cost (Dollars)

MPC + MEC = MSC

G S = MPC
110
B
105 10
10
100 A

D = MSB

4.5 5
Tons of Paper Per Year (Millions)
Implications of Figure 3.1

Market equilibrium
occurs where
MPC = MSB
Efficiency Requires that
MSC = MPC + MEC =
MSB
Positive externalities

 The marginal external benefit

is the dollar value of the benefit
to third parties from an
additional unit of production of
consumption of a good. This
occurs when there is a positive
externality.
Social Benefit

MSB = MPB + MEB

Figure 3.2 Market Equilibrium, A Positive
Externality and Efficiency
Price, Benefit, and Cost (Dollars)

45 Z
S = MSC

30 V
25 U

10 H
MPB + MEB = MSB

0
10 12 Inoculations Per
Year (Millions)
Internalization of
Externalities
An externality can be
internalized if there is a
policy that causes
market participants to
account for the costs or
benefits of their actions.
Corrective Taxes to
Negative Externalities

 Setting a tax equal to

the MEC will internalize
a negative externality.
Figure 3.4 A Corrective Tax

S’ = MPC + T = MSC
Price, Benefit, and Cost (Dollars)

S = MPC
G
110
B Net Gains in
105
Tax Revenue = Total Well-Being
100 T A
External Costs
95

D = MSB

4.5 5
Tons of Paper Per Year (Millions)
Results of a Corrective
Tax
Socially optimal levels
of production are
achieved.
The tax revenue is
sufficient to pay costs
to third parties.
Using a Corrective Tax

 Thegreenhouse effect and a

“Carbon Tax”
 If it is accepted that the greenhouse
effect is caused by burning carbon-
based fuels, a carbon tax can be
imposed to limit greenhouse gasses to
their socially optimal levels.
 It is called a carbon tax because the
amount of the tax would depend on the
amount of carbon in the fuel.
Theory of the Second Best

When one condition

for an optimum is
violated then
maintaining the others
will not guarantee a
second-best solution.
A Polluting Monopolist

InChapter 2 it was shown that

monopoly created a loss to
society. In this chapter it was
shown that a negative
externality causes a loss as
well.
The losses do not necessarily
add to one another. In fact, they
can cancel each other out.
Figure 3.5 A Second Best Efficient Solution

MPC + MEC = MSC

F
MPC
A
PM
B
Price

D = MSB
MR

0 QM Q*
Output per Year
Corrective Subsidies

Setting a subsidy
equal to MEB will
internalize a positive
externality
Figure 3.6 A Corrective Subsidy
Price, Benefit, and Cost (Dollars)

45 Z
S = MSC

R
30 V
25 U
Subsidy Payments

10 X
Y D' = MPBi + $20 = MSB
D = MPBi
0 10 12
Inoculations per Year (Millions)