Lecture Four: Public Finance

PART ONE: THE ECONOMIC BASIS

FOR GOVERNMENT ACTIVITY

Chapter 3: Externalities and

Government Policy

Dr. Yara El-Sehaimy

Ya b d e l k h a l e k @ e c u . e d u . e g
 Chapter 3 Outline
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Market failure and its types.

Externalities.
Internalization of externalities.
 Taxes
 Subsidies
 Market Failure
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 We can’t rely on markets to provide all goods and services in efficient

amounts!

 Market failure occur when efficiency condition is unattained and

MSB>MSC.

 There are 5 scenarios at which market failure is maximized:

1. Monopoly  Concentrated market Power
2. Effects of market transactions on 3rd parties other than buyers and sellers 
Externality
3. Lack of markets for goods with MBS>MSC  Public goods
4. Incomplete information  Asymmetric information
5. Economic stabilization
 MarketMarket
Failure
Failure Types
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Concentrate Asymmetric
Externalities Public Goods
Market Power Information
 MarketMarket
Failure
Failure Types
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Concentrate Asymmetric
Externalities Public Goods
Market Power Information

Individual Assignment Two

 Externalities
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 Are costs or benefits of market transaction not reflected in price.

 When externality exists, a 3rd party other than the buyer and the seller
of the item is affected by its production or consumption.

 The cost or benefit of of the 3rd party are not considered by either
buyers or sellers of an item whose production or use results in
externality.

 Market prices do not accurately reflect either all the MSB or MSC of the
traded items when externality involved.

 They actually diverge from equilibrium!

 Externalities Types
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Externalities
Positive
 Are benefits to 3rd parties other
than the buyers or the sellers of a good
or service not reflected in prices.
Buyers and sellers of goods that
results in +ve externality do not
consider the fact that each unit
produced provided benefits to others.
Negative
 Are costs to 3rd parties other than
the buyers or the sellers of a good or
service not reflected in prices.
Buyers and sellers of goods that
results in -ve externality do not
consider the fact that each unit
produced provided damage/ cost to
others.
 Negative Externalities
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 When –ve externality exists, the price of a good or service does not
reflect the full MSC of resources allocated to its production.

 Negative Externality Cost (NEC) = MSC + MEC

The The extra cost
minimum to 3rd parties
sum of money resulting
required to from
compensate production of
the producers another unit
for making of a good or
one extra service.
unit.
Not reflected
in the price of
a good or
service.
 Negative Externality
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Supply with –ve externality

Price
Supply

With externality MSC+MEC = P’*

Without externality MSC = P*

Demand

Q’* Q* Quantity
 Negative Externality
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Private + Social Cost

Price
Private Cost

P’*
P*

Demand

Q’* Q* Quantity

Is the new equilibrium is efficient or in efficient?

Give me 1 example of negative Externality?
 Positive Externalities
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 When +ve externality exists, the price of a good or service does not
reflect the full MSB of resources allocated to its production.

 Positive Externality Benefit (PEB) = MSB + MEB

Extra benefit The extra benefit
obtained by to 3rd parties
making one resulting from
more person production of
satisfies by another unit of a
using one extra good or service.
produced unit.
Not reflected in the
price of a good or
service.
 Positive Externality
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Price
Supply

With externality MSB+MEB = P’*

Without externality MSB = P*

Demand with +ve externality

Demand

Q* Q’* Quantity
 Positive Externality
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Price
Supply

P’*
P*

Private + Social Benefit

Private Benefit

Q* Q’* Quantity

Is the new equilibrium is efficient or in efficient?

Give me 1 example of Positive Externality?
 Internalization of Externalities
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 Externalities either positive or negative are available everywhere

around us! And they are represented in very small situations!

 We know what should be done to correct for externalities, the question

now is how it should be done?

 Internalization of externality occurs when the price of a good or service

reflect the full cost/benefit of producing it.
 Internalization of Externalities
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 Internalization of externality occurs when the price of a good or service

reflect the full cost/benefit of producing it.

Internalization Externalities

Positive Negative

MSB = MPB+MEB MSC = MPC+MEC

MSB reflects both private and social benefit MSC reflects both private and social cost
 Internalization of Externalities
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 Externalities either positive or negative are available everywhere around us!

And they are represented in very small situations!

 We know what should be done to correct for externalities, the question now is
how it should be done?

 Internalization of externality occurs when the price of a good or service reflect

the full cost/benefit of producing it.

 Internalization of externalities requires identification of the individuals

involved and measure the monetary value of the marginal external benefit or
cost.

 Therefore, the government can interfere the solve this issue to correct the
market!
 Internalization of –ve Externalities
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 The government can interfere in the case of negative externality in the

market through applying taxes.

 A corrective tax is designed to adjust the MPC of a good or service in

such a way to internalize/correct the –ve externality.
Tax = MEC
⸫ Market cost with –ve externality = MSC + Taxes
⸫ Equilibrium is achieved at the Efficiency condition

 Taxes collected by the government used to correct the damage occurred

in the market.
 Internalization of +ve Externalities
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 The government can interfere in the case of positive externality in the

market through applying subsidies.

 A corrective subsidy is a payment made by the government to either buyers

or sellers of a good or service so that the price paid by consumer is reduced.
Subsidy = MEB
⸫ Market benefit with +ve externality = MSB + Subsidy
⸫ Equilibrium is achieved at the Efficiency condition

 Subsidies distributed by the government used to correct the damage

occurred in the market.

 It is important to note that not all subsidies imposed by the government are
there to fight +ve externalities, some are there to fight other goals as
poverty.
 15 Minutes
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