Professorship in Faculty 07

Federal and Regional Financial Relations Prof. Dr. André W. Heinemann Business Studies & Economics

Public Sector Economics

Chapter 4
Externalities, Basics of Environmental Policy,
and Internalization Instruments
4.1 Externalities
Pecuniary and technological external effects

External effects

Pecuniary Technological
external effects external effects

 General interdependencies between market actors.
 Cause an increase or decrease in market prices within
the market system and activity indirectly affects the
welfare of another.
 Change of relative prices.
 Special interdependencies between market actors.
 Activity of one entity directly affects the welfare of
another in a way that is not reflected in a market
price.
 No change of relative prices.

No interference of markets, Interference of markets,

markets are efficient markets are not efficient

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4.1 Externalities
Definition

A cost or benefit that occurs when the activity of one entity directly affects the
welfare of another in a way that is outside the market mechanism.

 Whe the activity of an entity ( a person or firm) directly affect the welfare of another in
the way that is not reflected in the market price, that effect is called an externality.
Unlike effects that are transmitted through market prices, externalities reduce economic
efficiency.

 Example: Utility function of individual 𝐴 𝑈 𝐴 = 𝑈 𝐴 𝑥1𝐴 , 𝑥2𝐴 , … , 𝑥𝑛𝐴 , 𝑥𝐵

𝑒𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑒𝑓𝑓𝑒𝑐𝑡

 Externalities have no market price!

 Externalities can be negative (external cost) or positive (external benefit).

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4.2 An Externality Problem
Inefficiency

𝑀𝐵

𝑀𝑃𝐶 + 𝑀𝐷

𝑀𝑃𝐶

𝑥𝑃 𝑥

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4.2 An Externality Problem
Inefficiency

𝑀𝐵

𝑀𝑃𝐶 + 𝑀𝐷

𝑀𝑃𝐶

𝑥∗ 𝑥𝑃 𝑥

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4.3 Internalization
Internalization Instruments

Activities (mechanism):

 Social Conventions

 Mergers

 Government can intervene by levying taxes and granting of subsidies on certain market
activities
 PIGOUVIAN Tax / PIGOUVIAN Subsidy

 Assignment of property rights and bargaining

 COASE Theorem

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4.3 Internalization
Internalization of Negative Externality and PIGOUVIAN Tax

𝑀𝐵

𝑀𝑃𝐶 + 𝜏
𝑇 = 𝜏 ∙ 𝑥∗
𝑀𝑃𝐶

𝑥∗ 𝑥𝑃 𝑥

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4.3 Internalization
Negative External Effect and Analysis of a PIGOUVIAN Tax

𝑀𝑃𝐶 + 𝑀𝐷
𝑝 (Marginal social cost – MSC)

𝑀𝐵
(Marginal benefit)

ℎ
𝑀𝑃𝐶
𝑑 (Marginal private cost)

𝑔
𝑀𝐷
𝑐 (Marginal damage)

𝑏 𝑓

𝑎 𝑒
𝑄∗ 𝑄1 𝑄
Source: Rosen, Harvey S. and Ted Gayer (2014), Public Finance. 10th Global Edition, McGraw-Hill, p. 76.

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4.3 Internalization
Negative External Effect and Analysis of a PIGOUVIAN Tax

𝑀𝑃𝐶 + 𝑀𝐷
𝑝
𝑀𝐵
𝑀𝑃𝐶 + 𝜏
𝑐𝑑

𝑀𝑃𝐶
𝑑
𝑖

𝑀𝐷
𝑗
𝑐

𝑄∗ 𝑄1 𝑄
Source: Rosen, Harvey S. and Ted Gayer (2014), Public Finance. 10th Global Edition, McGraw-Hill, p. 85.

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4.3 Internalization
Negative External Effect and Analysis of a PIGOUVIAN Subsidy

𝑀𝑃𝐶 + 𝑀𝐷
𝑝
𝑀𝐵
𝑀𝑃𝐶 + 𝑧
𝑐𝑑

𝑘 𝑀𝑃𝐶
𝑑
𝑓
𝑔
𝑀𝐷
𝑐 ℎ

𝑄∗ 𝑄1 𝑄
Source: Rosen, Harvey S. and Ted Gayer (2014), Public Finance. 10th Global Edition, McGraw-Hill, p. 86.