Government actions in externalities

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Introduction
Lessons
  1. Government Actions in Externalities Overview
  2. How Government Regulates Negative Externalities
    • Property Rights
    • Taxes
    • Emissions Charges
    • Cap-and-Trade
  3. Using Pollution Tax for Negative Externalities
    • Add Tax to MC curve
    • S = MC + tax
    • Supply curve = Marginal social curve
    • Optimal social output achieved
    • Government gains Tax revenue
  4. How Government Regulates Positive Externalities
    • Public Production
    • Subsidies
    • Vouchers
    • Patents & Copyrights
  5. Using Subsidies for Positive Externalities
    • Subtract Marginal Social Cost with Subsidy
    • S1 = MSC - subsidy
    • Market Equilibrium at intersection of S1 & MB
    • Quantity same as optimal social output
Examples
Lessons
  1. Questions Relating to Negative Externalities
    Suppose a firm produces pesticides, but it also produces wastes which they dump into a lake. The following table shows the demand schedule and marginal cost for pesticides. Assume that the marginal external cost is equal to the marginal cost.

    Price

    Quantity

    Marginal Cost

    4

    50

    10

    8

    40

    8

    12

    30

    6

    16

    20

    4

    20

    10

    2


    1. If there are no regulations for the waste, what is the quantity and price of pesticides produced? What is the marginal external cost?
    2. If residents now have property rights for the lake, how would the firm change its quantity and price of pesticides?
  2. Suppose a firm produces greenhouse gas emissions for a product. The following graph shows the marginal social benefit and marginal private cost. Assume the marginal external cost is 4.

    Government Actions in Externalities

    1. If there are no regulations for the greenhouse gas emissions, what is the quantity and price of pesticides produced?
    2. The government implements a caps-and-trade to the product. What would be the maximum quantity set by the government to reduce greenhouse gas emissions?
    3. With caps-and-trade, what would the price of the product be? When do firms stop trading permits?
  3. Suppose a firm produces goods that pollutes a river nearby. The following table shows the demand schedule and marginal cost for the good. Assume that the marginal external cost is equal to the marginal cost.

    Price

    Quantity

    Marginal Cost

    2

    125

    5

    4

    100

    4

    6

    75

    3

    8

    50

    2

    10

    25

    1


    1. If there are no government actions to control pollution, what is the quantity and price of goods produced, and the marginal external cost of the pollution generated?
    2. If the government levies a pollution tax, what would the efficient quantity and price be for the good?
    3. What is the tax levied?
    4. What is the government tax revenue per day?
  4. Questions Relating to Positive Externalities
    The marginal cost of educating a student is a constant $2,000 a year, and the following table shows the student's marginal benefit curve. University education has an external benefits of $1,000 per student per year.

    Price (of Tuition in thousands)

    Quantity (student's per year in thousands)

    5

    50

    4

    100

    3

    150

    2

    200

    1

    250


    1. If all universities are private, and the education market is competitive, then what is the tuition and the number of students enrolled per year?
    2. If the government creates public universities, what tuition will universities charge and taxpayers pay to achieve an efficient number of students?
  5. The marginal cost of educating a student is a constant $2,000 a year, and the following table shows the student's marginal benefit curve. University education has an external benefit of $1,000 per student per year.

    Price (of Tuition in thousands)

    Quantity (student's per year in thousands)

    5

    50

    4

    100

    3

    150

    2

    200

    1

    250


    1. If the government decides to subsidize private universities, what subsidy would achieve the efficient number of university students?
    2. If the government offers vouchers to students who enroll into universities with no subsidy, what should the value of the voucher be to achieve the efficient number of university students?
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Topic Notes
How Government Regulates Negative Externalities

The government can take action against negative externalities in three ways
  1. Property Rights: By establishing these rights, we can confront producers with the costs of their actions. This gives them incentive to change the quantity supplied.

    Economically, firms realize their actions and external cost so their private MC curve becomes the MSC curve.

  2. How Government Regulates Negative Externalities  Property Rights
  3. Taxes: If the government sets a tax equal to the external cost, then the firm will have to pay both the private marginal cost and tax. This leads to the firms supply to be the marginal social cost. In other words,
  4. MPC + tax = MSC

  5. Emission Charges: The government sets a price per unit of pollution. The more pollution the firm makes, the more emissions charges the firm must pay. This is an alternative to taxes.

  6. Cap-And-Trade: The government assigns a permit which tells you the cap (pollution quota) of the firm. Each permit may be different for each firm.

    Note: firms trade permits until the marginal pollution cost is equal to the price of the permit.

Using Pollution Tax for Negative Externalities

Recall that the firms supply curve is the MPC curve.

S0 = MPC

We also have the demand curve MSD. When a pollution tax is implemented, we add the tax to the MPC curve. Thus, the firms supply curve is now

S1 = MPC + tax

Since the tax is equal to the external cost, then we also notice that

MSC = S1

Thus, the new market equilibrium is at the intersection of S1 and MSD curve.

Using Pollution Tax for Negative Externalities

How Government Regulates Positive Externalities

The government can take action against positive externalities in four ways:
  1. Public Production:: When the government implements public production, consumers realize the external benefits, thus changing their private MPB curve to the MSB curve. This achieves efficient market equilibrium

  2. How Government Regulates Positive Externalities  Public Production

  3. Subsidies: a government payment that is made to producers. By adding subsidies, the firms supply curve becomes

  4. S = MPC - Subsidy

    Since the product is cheaper to produce, firms produce more to compensate for the underproduction from external benefits.

  5. Vouchers: a token that is provided from the government and given to households. Consumer realizes the extra benefit gained from the token, and so the marginal private demand becomes the marginal social demand.

  6. How Government Regulates Positive Externalities  Vouchers

Using Subsidies for Positive Externalities

Recall that the firms supply curve S0 is the MPC curve, and the demand curve is MPD.

Suppose MSC = MPC. When subsidy is implemented, we subtract the subsidy from the MPC. Thus, the firms supply curve is now

S1 = MPC - Subsidy

Thus, the new market equilibrium is at the intersection of S1 and MPD curve.

Using Subsidies for Positive Externalities