ECONOMICS 504: Basic Economics

  • University of Baltimore
  • created by: Dr. Dan Gerlowski
  • Instructor: Dr. Stephan Tubene

Public Policies Towards Externalities

  • regulation
  • pigovian taxes and subsidies
  • tradable permits
Regulation
Can an externality simply be removed, or outlawed? Sure any government can pass almost any law it wishes at almost any point in time. If nucleur plants generate an externality simply make them illegal. The problem with the regulation approach is that it causes a mis-allocation of resources. Very often, regulation to limit an externality will have far reaching implications in other sectors of the economy.

Pigovian Tax

If we think of a market with a negative production externality such as that shown at the right. We see that the optimal, or efficient level of output is Q2 to be solda t a price of P2. The price P2 includes the cost of the externality.

The market outcome is, however Q1, sold at a price of P1. Clearly the market determined price of P1 does not "pay for" the externality.

A Pigovian Tax placed on the production of the good would amount to a per-unit produced amount charged by the government to cover the cost of the extenality. In other words the tax would shift the supply curve to the social cost supply function.
It is also possible to think of a Pigovian tax as a subsidy. If there were a good that created a positive externality in consumption then the market would underproduce that good. The efficient outcome would involve more output than provided by the market. A subsidy on the production (or consumption) of the good would encourage more produced to obtain an output more in line with the socially efficient one.
A Pigovian Tax On Gasoline? Alchohol?

Certain goods in the economy generate negative externalities by their consumption. Gasoline is an example. When gasoline is consumed, pollution, congestion, and other ill effects manifest themselves. Alchohol is another example, having intoxicated people running around, or driving around, is bad for everyone. One of the most compelling arguments in favor of taxing these types of goods is that the tax increases welfare in the society. Naturally the welfare effect identified here depends crucially on the price elasticity of demand for those goods. We have seen elsewhere in this course that the government has incentive to tax goods with inelastic demands.

Tradable Pollution Permits

The idea of tradable pollution permits is an easy one to understand. Lets suppose that the Environmental Protection Agency, EPA, has decided that society can withstand 500 cubic tons of blotto released into the atmosphere. (No, I don't know what blotto is, but it sounds really bad doesn't it?) The EPA bans the construction of any production facilities that produces blotto and identifies the 10 blotto creators in the country. These 10 facilities are not from the same industry, nor do they produce the same things. Each of the firms is then told it can only produce 50 = 500/10 cubic tons of blotto each year. The firms making blotto as a by-product to making profits come up with the idea of letting them buy and sell their permits to emit blotto among themselves, and among any newcomers to the industry.

Such a deal might be attractive from an individual firm's perspective because across different firms using different types of production methods the costs of reducing blotto emmissions might differ significantly. One firm may have a very easy time reducing its emmissions to the 10 cubic ton level, other firms may not.

Clearly if the firms are allowed to trade the permits to pollute, they are better off and nobody is worse off.

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