Managerial Economics

(Management Accounting 2)

Solving Externalities
Group 2

Submitted by:

Ballesteros, Dave Justin

Bisnan, Caryll Joy

Brigola, Rey

Buenavente, Paloma

BSA-1A

Submitted to:

Dr. Roberto D. Alagao

December 13, 2019
 Internalizing Externalities

An externality is internalized if the person or group generating the externality

incorporates into their own private or internal cost-benefit calculations the external
benefits in the case of positive and negative externality.

Numerous ways to adjust for, o internalize externalities:

1. Persuasion

Many negative externalities arise partly because person or group do not consider
other individuals when they decide to undertake an action.

2. Assigning Property Rights

Consider the idea that air pollution and ocean pollution both is example of
negative externalities-are the result of air and ocean being unowned. No one owns the
air, no one owns the ocean, and because no one does many individuals feel free to pun
intended to inherit waste into them.

3. Voluntary Agreement

Externalities can sometimes be internalizing through individual voluntary

agreements.

Suppose Pete and Sean live alone in a tiny island. They have agreed, between
themselves, that Pete owns the northern part of the island and Sean owns the southern
part. Pete occasionally plays his drums in the morning, and the sounds awaken Sean,
causing a negative externality problem. Pete wants to be free to play his drums in the
morning and Sean would like to sleep.

Suppose Sean values his sleep in the morning by a maximum of 6 oranges; that
is, he would give up 6 orange to be able to sleep without Pete playing his drums. On
the other hand, Pete values drum playing in the morning by 3 oranges. He would give
up a maximum of 3 oranges to be able to play his drums in the morning. Because Sean
values his sleep by more than Pete. They have an opportunity to strike a deal. Sean can
offer Pete some number of oranges greater than 3, but fewer than 6 to refrain from
playing his drums in the morning. The deal will make the both better off.

4. Transaction cost

Cost associated with making and reaching the agreement, must be relative to the
expected benefits of the agreement.
 Taxes and Subsidies

What Are Taxes?

Taxes are involuntary fees levied on individuals or corporations and enforced by

a government entity—whether local, regional or national—in order to finance
government activities. In economics, taxes fall on whomever pays the burden of the
tax, whether this is the entity being taxed, such as a business, or the end consumers of
the business’s goods. Taxes are not the most popular policy, but they are often
necessary. We will look at two methods to understand how taxes affect the market: by
shifting the curve and using the wedge method. First, we must examine the difference
between legal tax incidence and economic tax incidence.

What is a Subsidy?

A subsidy is a benefit given to an individual, business, or institution, usually by

the government. It is usually in the form of a cash payment or a tax reduction. The
subsidy is typically given to remove some type of burden, and it is often considered to
be in the overall interest of the public, given to promote a social good or an economic
policy.

Legal versus Economic Tax Incidence

When the government sets a tax, it must decide whether to levy the tax on the
producers or the consumers. This is called legal tax incidence. The most well-known
taxes are ones levied on the consumer, such as Government Sales Tax (GST) and
Provincial Sales Tax (PST). The government also sets taxes on producers, such as the
gas tax, which cuts into their profits. The legal incidence of the tax is actually irrelevant
when determining who is impacted by the tax.

When the government levies a gas tax, the producers will pass some of these
costs on as an increased price. Likewise, a tax on consumers will ultimately decrease
quantity demanded and reduce producer surplus. This is because the economic tax
incidence, or who actually pays in the new equilibrium for the incidence of the tax, is
based on how the market responds to the price change – not on legal incidence.

Tax – Shifting the Curve

The supply curve was derived from a firm’s Marginal Cost and that shifts in the
supply curve were caused by any changes in the market that caused an increase in MC
at every quantity level. This is no different for a tax. From the producer’s perspective,
any tax levied on them is just an increase in the marginal costs per unit. To illustrate
the effect of a tax, let’s look at the oil market again.

If the government levies a $3 gas tax on producers (a legal tax incidence on

producers), the supply curve will shift up by $3. As shown in Figure 4.8a below, a new
equilibrium is created at P=$5 and Q=2 million barrels. Note that producers do not
receive $5, they now only receive $2, as $3 has to be sent to the government. From the
consumer’s perspective, this $1 increase in price is no different than a price increase for
any other reason, and responds by decreasing the quantity demanded for the higher
priced good.

W h a t i f t h e l e

curve represents the consumers’ willingness to pay, the demand curve will shift down
as a result of the tax. If consumers are only willing to pay $4/gallon for 4 million gallons
of oil but know they will face a $3/gallon tax at the till, they will only purchase 4 million
gallons if the ticket price is $1. This creates a new equilibrium where consumers pay a
$2 ticket price, knowing they will have to pay a $3 tax for a total of $5. The producers
will receive the $2 paid before taxes.
Note that whether the tax is levied on the consumer or producer, the final result is the
same, proving the legal incidence of the tax is irrelevant.

Tax – The Wedge Method

Another method to view taxes is through the wedge method. This method
recognizes that who pays the tax is ultimately irrelevant. Instead, the wedge method
illustrates that a tax drives a wedge between the price consumers pay and the revenue
producers receive, equal to the size of the tax levied.

As illustrated below, to find the new equilibrium, one simply needs to find a $3
wedge between the curves. The first wedge tested is only $0.7, followed by $1.5, until
the $3.0 tax is found.

How do government subsidies help an industry?

Government subsidies help an industry by paying for part of the cost of the
production of a good or service by offering tax credits or reimbursements or by paying
for part of the cost a consumer would pay to purchase a good or service.

Increasing Production and Consumption

 Governments seek to implement subsidies to encourage production and
consumption in specific industries. On the supply side, government subsidies help an
industry by allowing the producers to produce more goods and services. This increases
the overall supply of that good or service, increases the quantity demanded for that
good or service and lowers the overall price of the good or service.

Increasing Savings

Since the government helps suppliers through tax credits or reimbursements, the
lower overall price of their goods and services is more than offset by the savings they
receive.

Tax Credits

On the consumer side, government subsidies can help potential consumers with
the cost of a good or service, usually through tax credits. A great example of this is
when consumers who refit their houses with solar panels receive a tax credit to offset
the high price of purchasing the new solar panels. This helps the renewable energy
industry by allowing more consumers to purchase the products associated with that
industry.

The Bottom Line

Government subsidies can help an industry on both the supplier side and the
consumer side. To implement subsidies, governments need to raise taxes or reallocate
taxes from existing budgets. There is also an argument that incentives in the form of
subsidies actually reduce the incentives of firms to cut costs.

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Though one of the advantages of subsidies is the greater supply of goods, a

shortage of supply can also occur. This is because lowered prices can lead to a sudden
rise in demand that many producers may find very hard to meet. Ultimately, it can lead
to very high demand that causes an increase in prices.

Increased taxation tends to discourage economic activity and limit economic

growth. The higher taxes are, the less money citizens will have to spend on goods and
services and lower consumption leads to less revenue for business.
 Pigou Theorem

Pigou Effect

The Pigou effect is a term in economics referring to the relationship between

consumption, wealth, employment and output during periods of deflation. Defining
wealth as the money supply divided by current price levels, the Pigou effect states that
when there is deflation of prices, employment (and thus output) will be increased due
to an increase in wealth (and thus consumption).

Alternatively, with the inflation of prices, employment and output will be

decreased, due to a decrease in consumption. The Pigou effect is also known as the
"real balance effect."

Pigouvian Tax

A Pigouvian tax is a tax placed on any good which creates negative externalities.
The aim of a Pigouvian tax is to make the price of the good equal to the social marginal
cost and create a more socially efficient allocation of resources.

It is named after the economist Arthur Pigou who developed the concept of
externalities in the 1920s.

•
I n a f r e e m a r k e t

social inefficiency.

• At Q1, the social marginal cost (SMC) is greater than the social marginal benefit
(SMB) – there is overconsumption.
• If the government place a tax equal to the external marginal cost, then
consumers will be paying the full social marginal cost. (SMC)

• This will reduce the demand from Q1 to Q2 and this will be socially efficient
because at Q2 (SMC=SMB)

Pigou on Externalities

In 1920, Arthur C. Pigou wrote The Economics of Welfare which is an early

exposition of this concept of externalities.

Pigou noted that private business pursued their own marginal private interests.
However, industrialists were not concerned with any external costs to others in society.
In other words, they had no incentive to internalize the full social costs of their actions,
and this led to a deadweight welfare loss.

“In general industrialists are interested, not in the social, but only in the private,
net product of their operations.

They (externalities) are rendered, again, when the owner of a site in a

residential quarter of a city builds a factory there and so destroys a great part of the
amenities of the neighboring sites; or, in a less degree, when he uses his site in such a
way as to spoil the lighting of the houses opposite …”

Pigou used an example of a contractor building a factory in the middle of a

neighborhood. The factory leads to external costs faced by those living in the locality.
These external costs include:

• Pollution

• Congestion

• Damage to health

• Loss of light

Tax on Alcohol

Pigou noted that alcohol producers benefited from the sale of alcohol but did not
have to pay the external costs – associated with heavy drinking, such as the police,
health care and prisons. Therefore, he argued that a tax on alcohol could discourage
excess drinking but more importantly raise public funds to deal with the external costs
of alcohol drinking.

Double Dividend of Pigouvian Tax

A Pigouvian tax can be justified on the grounds that it reduces the production of
harmful substances and reduces problems such as pollution, congestion and
drunkenness. But, as an additional benefit, it causes increased tax revenue that the
government can use for public spending. The funds raised can be used for a Pigouvian
subsidy.

Potential Problems of Pigouvian Tax

• How much? In practice, it can be difficult to measure the external costs of

producing/consuming goods. For example, the external costs of driving a car include
pollution, asthma, congestion, and the risk of accidents.

• Administration costs. There are external costs of driving in a town, but to place a
congestion tax for small market towns is relatively impractical. Therefore, the tax is not
practical.

• Evasion. A tax on good can create an incentive to find illegal methods. For
example, a tax on rubbish may be justified due to external costs. However, this may
lead to illegal fly-tipping because consumers find a way to avoid the tax. This could
create a bigger problem than the external costs of legal rubbish disposal.

• Political reluctance. The biggest problem is likely to be the political costs of

introducing a new tax. For example, a tax on meat has been proposed, but there is
great reluctance to introduce new taxes.

• Tax may be insufficient. Pigou noted that for some problems, such as poor food
standards, a tax is not appropriate – a better solution is to have regulations on
minimum food standards or ban certain practices.
Pigouvian subsidy

A Pigouvian subsidy works on the same basis – if a good has positive

externalities, then it will be under-consumed in a free market. The government can give
a subsidy equal to the marginal external benefit of the good.

Examples of Pigouvian tax

• Tax on sugary drinks

• Tax on tobacco

• Congestion charge

• Carbon tax

• Tax on petrol

Pigou Club

The Pigou club is a group of economists who support the idea of using taxes to
charge the full social cost for goods. A prominent advocate is Greg Mankiw.

Pigouvian taxes are popular among economists. First, they are often the least
invasive way to remedy a market failure. They can restore an efficient allocation of
resources without requiring a heavy-handed government intervention into the specific
decisions made by households and firms. Second, they raise revenue that the
government can use to reduce other taxes, such as income taxes, which distort
incentives and cause deadweight losses.”

The Pigouvian Theory of Externalities and Their Implications for Environmental Planning

Most planners are likely to remember reviewing the economic argument for
planning in any standard planning theory course: market failures such as those related
to externalities and information asymmetries are a justification for the intervention of
government, and planning is a function of government, therefore market failures justify
planning.

But what are some of the competing theories surrounding externalities? And
what are the planning related policy implications these theories present? Hardin’s
Tragedy of the Commons is discussed in some depth in most intro economic courses
and is at least briefly introduced in many non-econ courses in discussions related to
environmental policy. Since many planners are probably familiar with this theory, let’s
move a little beyond Hardin’s work. Instead, look at two other competing theories.

The Coase Theorem is closely related to Hardin’s work in that they both rely on a
similar assumption. The Pigouvian analysis of externalities provides a competing set of
policy implications. I feel the Pigouvian analysis is probably a stronger framework for
understanding the role of planners under most circumstances, however planners must
also be able to recognize the conditions appropriate for the application of the Coase
theorem.

A Pigouvian Analysis of Negative Externalities

Pigou’s Theory of Externalities

The supply and demand curve make a number of assumptions, but for our
purposes, two are particularly important:

1. Supply = Marginal Personal Cost (MPC) = Marginal Social Cost (MSC)

2. Demand = Marginal Personal Benefit (MPB) = Marginal Social Benefit (MPB)

Essential, these two assumptions comprise the assumption that there are no
externalities.
How Does a Pigouvian Tax Work?

Under free market conditions, a negative externality establishes a market

equilibrium when the social marginal benefit (SMB) is equal to the personal marginal
cost (PMC₁), which is lower than the social marginal cost (SMC) due to the additional
costs created by the economic activity. Such a market equilibrium is not efficient.

In the ideal world, the Pigouvian tax will be imposed at an amount equal to the
costs associated with the negative externality. When Pigouvian taxes are imposed, the
supply of the economic activity producing the negative externality will decrease.

Therefore, the quantity demanded will decrease while the price will increase.
Therefore, the market equilibrium will become socially efficient because the social
marginal cost will become equal to the private marginal cost.

Advantages of Pigouvian Tax

In some cases, Pigouvian taxes can effectively deal with the problem of negative
externalities. Some of the advantages include:

1. Fosters market efficiency

Pigouvian taxes promote market efficiency by incorporating the additional costs

imposed by negative externalities.
2. Discourages harmful activities

In certain cases, Pigouvian taxes may effectively discourage the activities that
lead to negative externalities. For example, the introduction of a carbon tax may place a
significant burden on a company that produces substantial emission gases. Therefore, a
company may decide to transfer to operations that produce fewer emission gases.

3. Generates additional government revenue

Pigouvian taxes generate additional revenues to the government. The additional

funds may be used to subsidize initiatives and programs that will further challenge
negative externalities.

Disadvantages of Pigouvian Tax

Despite their benefits, Pigouvian taxes are frequently criticized because of the
following reasons:

1. Hard to measure

In theory, Pigouvian taxes must be equal to the costs generated by the negative
externality. However, in the real world, the precise measurement of the costs is not
always possible. Thus, in practice, Pigouvian taxes are less effective than in theory.

2. Political issues

The imposition of Pigouvian taxes is frequently associated with political problems.

Government attempts to introduce such taxes generally face resistance from lobbyists
who support parties that can be affected by the taxes (e.g., tobacco producers).
Therefore, Pigouvian taxes are not always an optimal solution from a political
perspective.

KEY TAKEAWAYS

 The Pigou effect states that a deflation in prices will result in increase in
employment and wealth, enabling the economy to return to its "natural rates."
 Harvard economist Robert Barro has contended that the government cannot
create a "Pigou effect" by issuing more bonds.
  The "Pigou effect" has limited applicability in explaining Japan's deflationary
economy.

Coase Theorem

The Coase Theorem (named after the British economist Ronald Coase) is a
famous theorem that addresses the question of how effectively private markets can
deal with externalities. In essence, it states that private parties can solve the problem
of externalities on their own, if they can bargain over the allocation of resources
without cost.

The Coase Theorem, states that in the presence of an externality, private parties
will arrive at an efficient outcome without government intervention. According to the
theorem, if trade in an externality is possible and there are no transaction costs,
bargaining among private parties will lead to an efficient outcome regardless of the
initial allocation of property rights.

Before we start, it is important to note that the Coase Theorem is a theoretical
construct. In reality, bargaining always comes at a certain cost (e.g. opportunity costs).
However, looking at the theorem will give you a better understanding of why the
problem of externalities persists in reality. So, let’s get started.

Key Takeaways

● The Coase Theorem argues that under the right conditions’ parties to a dispute
over property rights will be able to negotiate an economically optimal solution,
regardless of the initial distribution of the property rights.
● The Coase Theorem offers a potentially useful way to think about how to best
resolve conflicts between competing businesses or other economic uses of
limited resources.
● In order for the Coase Theorem to apply fully, the conditions of efficient,
competitive markets, and most importantly low transactions costs, must occur.
two parties will be able to bargain and reach an efficient outcome in the
presence of an externality.

(In practice, transaction costs are rarely low enough to allow for efficient
bargaining and hence the theorem is almost always inapplicable to economic
reality.)

Government intervention is not always necessary to address externalities.

Private actors will sometimes arrive at their own solutions.
There are several types of private solutions to market failures:

Moral codes: Moral codes guide individuals’ behavior. Individuals know that
certain actions are simply not “the right thing to do” or would elicit disapproving
reactions from others. This is illustrated in the case of littering. The likelihood of
being fined may be small, but moral codes provide an incentive to refrain from
littering.

Charities: Charities channel donations from private individuals towards fighting to

limit behaviors that result in negative externalities or promoting behaviors that
generate positive externalities. The former can be seen in the case of
organizations that protect the environment, while the latter is exemplified
through organizations that raise money for education.

Business mergers or contracts in the self-interest of relevant parties: Two

businesses that offer positive externalities to each other can merge or enter into
a contract that makes both parties better off.

The Coase theorem, which was developed by Ronald Coase, posits that two
parties will be able to bargain with each other to reach an agreement that
efficiently addresses externalities. However, the theorem notes several conditions
in order for such a solution to occur, including low transaction costs (the costs
the parties incur by negotiating and coming to agreement) and well-defined
property rights. If the conditions are met, the bargaining parties are expected to
reach an agreement where everyone is better off. In practice, however,
transaction costs do exist, and the bargaining process does not always run
smoothly. As a result, private individuals often fail to resolve problems.

EXAMPLE

The Jones family plants pear trees on their property which is adjacent to
the Smith family. The Smith family gets an external benefit from the Jones
family’s pear trees because they pick up the pears that fall on the ground on
their side of the property line (see ). This is an externality because the Smith
family does not pay the Jones family for the utility received from gathering fallen
pears. As a result, the Jones family plants too few pear trees. In response, the
Jones family can put up a net that will prevent pears from falling on the Smith’s
side of the property line, eliminating the externality. Alternatively, the Jones
could impose a cost on the Smith family if they want to continue to enjoy the
pears from the pear trees. Both parties will be better off if they can agree to the
 second scenario, as the Smith family will continue to enjoy pears and the Jones
family can increase the production of pears.

Efficient Solution: According to the Coase theorem, two private parties will be able to bargain
with each other and find an efficient solution to an externality problem.

Advantage

Solution is efficient when conditions are right.

Disadvantage

Theorem Breaks down with transaction costs

Theory in Practice

Pigou vs. Coase

The first editor of the Journal of Law and Economics was Aaron Director. In
1959, Director published an Article by Ronald Coase Entitled “The Federal
Communications and Commission.” In the article Coase took issue with economist A.C.
Pigou, A trailblazer in the area of externalities and market failure. Who had argued that
government should use taxes and subsidies to adjust for negative and positive
externalities, respectively? Coase argued that in the case of negative externalities, it is
not clear that the state should tax the person imposing the negative externality.