Chapter 3 (p. 42-85)
3.1 The theory of externalities
Externalities = impacts that affect the well-being of those outside of a market
transaction; can be positive or negative
- Negative example = pollution created by producers
- Positive example = trees planted by landowners → they absorb CO2 and provide
habitat for wildlife
Supply curve = marginal cost of production → costs of producing one more unit of a
good or service
Demand curve = marginal benefit → perceived benefits consumers obtain from
consuming one additional unit
Intersection supply and demand = equilibrium price → represents economic efficiency:
it maximizes the total (net social) benefits from the market (without externalities)
Internalizing external costs/externalities = using approaches such as taxation to
incorporate external costs into market decisions
- External costs = costs, not necessarily monetary, that is not reflected in a market
transaction
- Problem = assigning monetary value to environmental damages → difficult, but
will have to in some way
Social marginal cost curve = private production costs (labour, electricity, steel etc.) +
environmental costs (costs of negative externalities) → total social costs
- Above original market supply curve
o In simple example: social and private costs are parallel
o In reality: external costs are likely to increase when more is produced as
for example air pollution exceeds critical levels and congestion becomes
more severe
- Market equilibrium is now not the economically
efficient outcome
o When costs exceeds benefits → does not
make sense to produce more
o So, the marginal equilibrium is (Q*): when
the marginal benefits and marginal social
costs intersect = socially efficient (market
situation in which net social benefits are
maximized, at P*)
,Pigouvian tax = most common way to internalize negative externality → aka polluter pays
principle
- A per-unit tax set equal to the external damage caused by an activity, such as a
tax per ton of pollution emitted equal to the external damage of a ton of pollution
o The higher the tax, the more the cost curve shifts upward
- Polluter pays principle = the view that those responsible for pollution should pay
for the associated external costs, such as health costs and damage to wildlife
habitats
If Pigouvian tax is equal to externality damage per
product, then marginal cost of production is equal to
social marginal cost curve = the “correct” tax amount
➔ Note that though the tax is levied on producers, a
portion of the tax is passed on to consumers in the
form of a price increase (P market → P*), which
causes consumers to cut back their purchases (Q
market → Q*)
So, tax to counter negative externalities? → production of all good or services result in
some pollution damages → tax all?
2 factors why not to tax all products:
1. Some products cause minimal environmental damages, and the small amount of
taxes collected may not be worth the costs of estimating the “right” tax (research
and analysis)
2. Administrative costs of imposing and collecting tax may outweigh revenues
So, tax not on final consumer product, but tax at the level of raw production inputs (oil,
cotton etc.) → Upstream tax = tax implemented as near as possible to the point of
natural resource extraction
➔ Focus on materials that cause most widespread damage: fossil fuels etc.
o Limits administrative complexity of tax collection and avoids need for
estimating appropriate tax for a lot of different products
Other issue = how tax burden is distributed between producer and consumer
➔ “taxes are simply passed on to consumers in terms of higher prices” → NO:
sometimes burden lies more heavily on consumers, sometimes on producers
Elasticities of supply and demand = the sensitivity of quantity supplies and demanded to
prices
, - Elastic supply = an increase in prices results in a larger change in quantity
supplied;
o Inelastic supply = an increase in prices results in a small change.
- Elastic demand = an increase in prices results in a larger change in quantity
demanded;
o Inelastic demand = an increase in prices results in a small change
Other concern about tax = a tax can fall disproportionately on certain income groups
➔ Use some revenue to counteract tax impact on low-income households (tax
credits, rebates etc.)
Positive externality = additional social benefit from a good or
service beyond the private, or market, benefits (e.g. solar energy)
- Upward shift of demand curve = represents total social
benefits of each unit
- Subsidy to correct the market inefficiency when positive
externality is present
o Subsidy = payment to a producer to provide an
incentive for it to produce more of a good/service
▪ Sometimes subsidy is paid to consumers to
stimulate purchases
o Lowers the supply curve when paid to producers
o Demand curve shifts upward and to the right when
paid to consumers (higher market price, but lower
effective price)
3.2 Welfare analysis of externalities
Welfare analysis = tool that analyses the total costs and benefits of alternative policies
to different groups, such as producers and consumers
- Areas on supply and demand graph can be used to measure total benefits and
costs
o Area under market demand curve = total benefits to consumers
o Area under market supply curve = total costs to producers
Consumer surplus = total net benefits for consumers (area A) → difference between
their benefits from the consumption and the price PM they pay
Producer surplus = total net benefits for producers (area B) → difference between their
production costs and the price PM they receive
, In absence of externalities, market equilibrium is economically efficient because it
maximizes net social benefit (A+B)
With externalities, net social benefits = A’+B’ – C (externality damage/loss)
When tax internalized:
- Equilibrium shifts from Qm to Q*
- Net social welfare has increased → compare net
welfare before (3.7) and after (3.8) tax
o New consumer surplus = A’’ ; new producer
surplus = B’’
- Externality damages are area D, which is less than
the externalities in area C → total tax revenue =
area D → so revenue equals externality damages
Net social welfare = A’’ + B’’ – D + D = A’’ + B’’
Before tax: net social welfare was A’ + B’ – C → As A’’ + B’’ = A’ + B’, net social welfare has
increased as a result of the Pigouvian tax by area C
Note: Even after tax, society is still left with pollution damages of area D! → this is the
optimal amount of pollution based on current production costs and technologies
- Optimal pollution = the pollution level that maximises net social benefits
- Why not zero? → only way to achieve zero pollution is to have zero production→
not going to happen, so we will have to determine an optimal pollution level
- Problem with concept→ is it really optimal? if demand increases, optimal
pollution level will increase, but you don’t want that
o Instead set a maximum level of acceptable pollution based on health and
ecological considerations rather than economic analysis
3.1 The theory of externalities
Externalities = impacts that affect the well-being of those outside of a market
transaction; can be positive or negative
- Negative example = pollution created by producers
- Positive example = trees planted by landowners → they absorb CO2 and provide
habitat for wildlife
Supply curve = marginal cost of production → costs of producing one more unit of a
good or service
Demand curve = marginal benefit → perceived benefits consumers obtain from
consuming one additional unit
Intersection supply and demand = equilibrium price → represents economic efficiency:
it maximizes the total (net social) benefits from the market (without externalities)
Internalizing external costs/externalities = using approaches such as taxation to
incorporate external costs into market decisions
- External costs = costs, not necessarily monetary, that is not reflected in a market
transaction
- Problem = assigning monetary value to environmental damages → difficult, but
will have to in some way
Social marginal cost curve = private production costs (labour, electricity, steel etc.) +
environmental costs (costs of negative externalities) → total social costs
- Above original market supply curve
o In simple example: social and private costs are parallel
o In reality: external costs are likely to increase when more is produced as
for example air pollution exceeds critical levels and congestion becomes
more severe
- Market equilibrium is now not the economically
efficient outcome
o When costs exceeds benefits → does not
make sense to produce more
o So, the marginal equilibrium is (Q*): when
the marginal benefits and marginal social
costs intersect = socially efficient (market
situation in which net social benefits are
maximized, at P*)
,Pigouvian tax = most common way to internalize negative externality → aka polluter pays
principle
- A per-unit tax set equal to the external damage caused by an activity, such as a
tax per ton of pollution emitted equal to the external damage of a ton of pollution
o The higher the tax, the more the cost curve shifts upward
- Polluter pays principle = the view that those responsible for pollution should pay
for the associated external costs, such as health costs and damage to wildlife
habitats
If Pigouvian tax is equal to externality damage per
product, then marginal cost of production is equal to
social marginal cost curve = the “correct” tax amount
➔ Note that though the tax is levied on producers, a
portion of the tax is passed on to consumers in the
form of a price increase (P market → P*), which
causes consumers to cut back their purchases (Q
market → Q*)
So, tax to counter negative externalities? → production of all good or services result in
some pollution damages → tax all?
2 factors why not to tax all products:
1. Some products cause minimal environmental damages, and the small amount of
taxes collected may not be worth the costs of estimating the “right” tax (research
and analysis)
2. Administrative costs of imposing and collecting tax may outweigh revenues
So, tax not on final consumer product, but tax at the level of raw production inputs (oil,
cotton etc.) → Upstream tax = tax implemented as near as possible to the point of
natural resource extraction
➔ Focus on materials that cause most widespread damage: fossil fuels etc.
o Limits administrative complexity of tax collection and avoids need for
estimating appropriate tax for a lot of different products
Other issue = how tax burden is distributed between producer and consumer
➔ “taxes are simply passed on to consumers in terms of higher prices” → NO:
sometimes burden lies more heavily on consumers, sometimes on producers
Elasticities of supply and demand = the sensitivity of quantity supplies and demanded to
prices
, - Elastic supply = an increase in prices results in a larger change in quantity
supplied;
o Inelastic supply = an increase in prices results in a small change.
- Elastic demand = an increase in prices results in a larger change in quantity
demanded;
o Inelastic demand = an increase in prices results in a small change
Other concern about tax = a tax can fall disproportionately on certain income groups
➔ Use some revenue to counteract tax impact on low-income households (tax
credits, rebates etc.)
Positive externality = additional social benefit from a good or
service beyond the private, or market, benefits (e.g. solar energy)
- Upward shift of demand curve = represents total social
benefits of each unit
- Subsidy to correct the market inefficiency when positive
externality is present
o Subsidy = payment to a producer to provide an
incentive for it to produce more of a good/service
▪ Sometimes subsidy is paid to consumers to
stimulate purchases
o Lowers the supply curve when paid to producers
o Demand curve shifts upward and to the right when
paid to consumers (higher market price, but lower
effective price)
3.2 Welfare analysis of externalities
Welfare analysis = tool that analyses the total costs and benefits of alternative policies
to different groups, such as producers and consumers
- Areas on supply and demand graph can be used to measure total benefits and
costs
o Area under market demand curve = total benefits to consumers
o Area under market supply curve = total costs to producers
Consumer surplus = total net benefits for consumers (area A) → difference between
their benefits from the consumption and the price PM they pay
Producer surplus = total net benefits for producers (area B) → difference between their
production costs and the price PM they receive
, In absence of externalities, market equilibrium is economically efficient because it
maximizes net social benefit (A+B)
With externalities, net social benefits = A’+B’ – C (externality damage/loss)
When tax internalized:
- Equilibrium shifts from Qm to Q*
- Net social welfare has increased → compare net
welfare before (3.7) and after (3.8) tax
o New consumer surplus = A’’ ; new producer
surplus = B’’
- Externality damages are area D, which is less than
the externalities in area C → total tax revenue =
area D → so revenue equals externality damages
Net social welfare = A’’ + B’’ – D + D = A’’ + B’’
Before tax: net social welfare was A’ + B’ – C → As A’’ + B’’ = A’ + B’, net social welfare has
increased as a result of the Pigouvian tax by area C
Note: Even after tax, society is still left with pollution damages of area D! → this is the
optimal amount of pollution based on current production costs and technologies
- Optimal pollution = the pollution level that maximises net social benefits
- Why not zero? → only way to achieve zero pollution is to have zero production→
not going to happen, so we will have to determine an optimal pollution level
- Problem with concept→ is it really optimal? if demand increases, optimal
pollution level will increase, but you don’t want that
o Instead set a maximum level of acceptable pollution based on health and
ecological considerations rather than economic analysis
