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Government actions in externalities
- Intro Lesson: a7:54
- Intro Lesson: b2:41
- Intro Lesson: c6:58
- Intro Lesson: d4:58
Government actions in externalities
Lessons
How Government Regulates Negative Externalities
The government can take action against negative externalities in three ways
Using Pollution Tax for Negative Externalities
Recall that the firm’s 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 firm’s 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.
How Government Regulates Positive Externalities
The government can take action against positive externalities in four ways:
Using Subsidies for Positive Externalities
Recall that the firm’s 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 firm’s supply curve is now
S1 = MPC - Subsidy
Thus, the new market equilibrium is at the intersection of S1 and MPD curve.
The government can take action against negative externalities in three ways
- 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. - 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 firm’s supply to be the marginal social cost. In other words,
- 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.
- 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 firm’s supply curve is the MPC curve.
We also have the demand curve MSD. When a pollution tax is implemented, we add the tax to the MPC curve. Thus, the firm’s supply curve is now
Since the tax is equal to the external cost, then we also notice that
Thus, the new market equilibrium is at the intersection of S1 and MSD curve.

How Government Regulates Positive Externalities
The government can take action against positive externalities in four ways:
- 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
- Subsidies: a government payment that is made to producers. By adding subsidies, the firm’s supply curve becomes
- 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.

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

Using Subsidies for Positive Externalities
Recall that the firm’s 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 firm’s supply curve is now
Thus, the new market equilibrium is at the intersection of S1 and MPD curve.

- IntroductionGovernment Actions in Externalities Overviewa)How Government Regulates Negative Externalities
- Property Rights
- Taxes
- Emissions Charges
- Cap-and-Trade
b)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
c)How Government Regulates Positive Externalities- Public Production
- Subsidies
- Vouchers
- Patents & Copyrights
d)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
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11.
Government & Inequalities
11.1
Externalities
11.2
Government actions in externalities
11.3
Public goods