Part 2 – Public Expenditure: Public Goods and Externalities

Public Finance 10th Edition Rosen

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Chapter 5 – Externalities

Brief Outline
1. The Nature of Externalities
2. Graphical Analysis
a. Implications
b. Conclusion
3. Private Responses
a. Bargaining and the Coase Theorem
b. Mergers
c. Social Conventions
4. Public Responses to Externalities: Taxes and Subsidies
a. Taxes
b. Subsidies
5. Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
a. Emissions Fee
b. Cap-and-Trade
c. Emissions Fee versus Cap-and-Trade
d. Command-and-Control Regulation
6. The US Response
a. Progress with Incentive-Based Approaches
7. Implications for Income Distributions
a. Who Benefits?
b. Who Bears the Cost?
8. Positive Externalities
a. A Cautionary Note

Answers to End-of-Chapter Questions

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 Chapter 5 - Externalities

1. Before passengers were charged for checked bags, they would choose whether to check
bags or carry them on based on whether they were willing to trade time for the hassle of
dealing with carry-on bags. That is, passengers who valued saving time by not having to
deal with baggage claim more than the cost of dealing with carry-on baggage will choose
to carry on. The fact that passengers are now charged for checked baggage but not for
baggage carried onto the plane will inefficiently allocate overhead space. Passengers will
carry on more and bigger bags to save the fee charged, resulting in full overhead luggage
containers. Overhead space will go to the first passengers on the plane, rather than being
distributed more evenly. Bags checked (without a charge) at the gate forces some who
would choose to carry on even without the fee to have to check, which is a loss in
efficiency. Those who elect to carry on to avoid the fee, but would rather check their bags,
also result in an inefficiency.

2. The Coase theorem suggests that the church and the comedy club could negotiate. If the
church possessed the right to the “noise” in the building, the comedy club could pay the
church to be quiet. If the comedy club possessed the right to quiet in the building, the
church could compensate the club for the noise.

3. It is the case that a carbon tax would be passed on to the consumer. The tax raises costs to
the producer for producing the final good. These increased costs would decrease supply,
which will increase the price of that final good. In a cap and trade system, businesses must
purchase permits in order to emit carbon. If the cost of purchasing and using abatement
equipment is less than the cost of buying a permit, the business will use abatement
equipment. In either case (buying a permit or using abatement equipment) costs for the
producer increase, decreasing supply and increasing the price of the final good. If the
carbon tax and the number of permits issued in the cap and trade system were set
appropriately, the outlays for both programs would be the same.

4.

a. The number of parties per month that would be provided privately is P.

b. See schedule MSBp.

c. P*. Give a per-unit subsidy of $b per party to induce the correct number of parties.

d. The optimal subsidy is $b. The total subsidy=abcd. “Society” comes out ahead by
ghc, assuming the subsidy can be raised without any efficiency costs. (Cassanova’s

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Part 2 – Public Expenditure: Public Goods and Externalities

friends gain gchd; Cassanova loses chd but gains abcd, which is a subsidy cost to
government.)

5. The payment for signing a waiver is a negotiation as suggested by the Coase Theorem. If
residents accept the payment and sign the waiver, they are signaling that the noise cost to
them is less than the payment. If the residents choose not to accept the payment and sign
the waiver, the payment is not great enough to cover the cost of the noise. The Coase
Theorem suggest in this case that further negotiation could occur.

6. On the surface, the tax on saturated fat seems like a Pigouvian tax, if you assume that the
$3 is equivalent to the level of the damage from the saturated fats. The commentator is not
correct in his criticism that the tax is levied on an input rather an outcome. If the tax is
properly set and is the direct cause of unhealthy consumers, the efficient level of saturated
fat will be consumed. However, this tax suffers from the problem of assuming that the
saturated fat leads directly to poor health outcomes and is the only source of unhealthy
outcomes. Some consumers are healthy no matter the level of consumption of saturated
fats. Others are unhealthy even with no consumption of the saturated fats. And many
consumers will simply reallocate their consumption to nontaxed unhealthy foods.

7.
a. It is very likely that the farmer could negotiate with the neighbors, provided
property rights are clearly defined. The Coase Theorem is therefore applicable.

b. It is unlikely that negotiation could result in an efficient outcome in this case. It is

likely that there are a great number of farmers involved in both harvesting ants and
growing trees, making negotiation very difficult.

c. Property rights are not being enforced, making negotiation through the Coase
Theorem impossible.

d. There are too many people involved for private negotiation.

8.
a. The price of imported oil does not reflect the increased political risk by effectively
subsidizing authoritarian regimes like those in Saudi Arabia.

b. The tax would estimate the marginal damage (e.g., the increased instability in the
Middle East, etc.) by importing oil from Saudi Arabia.

c. The supply of TGRs is vertical at 104.5 billion if government seeks to reduce

consumption of gasoline to 104.5 billion. Consumers must have one TGR in order
to buy one gallon of gasoline, plus they must pay the price at the pump. Limiting
TGRs effectively limits the demand for gasoline, so the price per gallon will fall,
but consumers must have TGRs in order to purchase gasoline. If the market price
of one TGR is $0.75, this means that supply and demand intersect at $0.75, as
shown in the graph. This kind of program curbs consumption without giving
government more revenue because consumers are purchasing the TGRs from each

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 Chapter 5 - Externalities

other. However, the total amount of TGRs is limited by government. Those

consumers seeking to purchase more gasoline than allowed by the initial allocation
of TGRs can purchase additional TGRs from other consumers at the market price
of $0.75. By choosing to use a TGR to purchase gasoline, a consumer incurs an
opportunity cost equal to $0.75 since they cannot sell the TGR once it has been
used.

$ Supply of TGRs

$0.75

Demand for TGRs

104.5 billion TGRs

9. The use of the drug to treat sick cows leads to a positive externality (the benefit enjoyed
by air travelers) as well as a negative externality (the costs created by a larger number of
rats and feral dogs). Banning the drug might raise or lower efficiency, depending on
whether the positive externality is larger or whether the negative externality is larger.
There are many ways to design incentive-based regulations. Policymakers could determine
the efficient level of drug usage and then either allocate or sell the right to use the drug for
sick cows.

10. The program matches prices to changes in demand, fluctuating as demand changes. This
results in higher efficiency. Drivers will respond efficiently by choosing to park based on
their willingness to pay.

11.
a. When the Little Pigs hog farm produces on its own, it sets marginal benefit equal
to marginal cost. This occurs at 4 units.

b. The efficient number of hogs sets marginal benefit equal to marginal social cost,
which is the sum of MC and MD. At 2 units, MB=MSC=1600.

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Part 2 – Public Expenditure: Public Goods and Externalities

c. The efficient number of hogs sets marginal benefit equal to marginal social costs.
At 3 hogs, MB=MSC=1600.

12. Private Marginal Benefit = 10 - X

Private Marginal Cost = $5

External Cost = $2

Without government intervention, PMB = PMC; X = 5 units.

Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units.

Gain to society is the area of the triangle whose base is the distance between the efficient
and actual output levels, and whose height is the difference between private and social
marginal cost. Hence, the efficiency gain is ½ (5 - 3)(7 - 5) = 2

A Pigouvian tax adds to the private marginal cost the amount of the external cost at the
socially optimal level of production. Here a simple tax of $2 per unit will lead to efficient
production. This tax would raise ($2) (3 units) = $6 in revenue.

13.
a. The total cost of emissions reduction is minimized only when the marginal costs
are equal across all polluters, therefore a cost-effective solution requires that MC1
= MC2 or that 300e1 = 100e2. Substituting 3e1 for e2 in the formula e1 + e2 = 40
(since the policy goal is to reduce emissions by 40 units) yields the solution. It is
cost-effective for Firm 1 to reduce emissions by 10 units and for Firm 2 to reduce
emissions by 30 units.

b. In order to achieve cost-effective emission reductions, the emissions fee should

beset equal to $3,000. With this emissions fee, Firm 1 reduces 10 units and Firm 2
reduces 30 units, but Firm 1 has to pay $3,000 for each unit of pollution they
continue to produce, which gives them a tax burden of $3,000 x 90 (Firm 1
generated 100 units in the absence of government intervention) or $270,000. Firm
2 has a lower tax burden because it is reducing emissions from 80 units to 50units.
Firm 2 pays $3,000 x 50 = $150,000. As the text concludes, the firm that cuts back
pollution less isn’t really getting away with anything because it has a larger tax
liability than if it were to cut back more.

c. From an efficiency standpoint, the initial allocation of permits does not matter. If
the two firms could not trade permits, then Firm 2 would have to undertake all of
the emissions reduction. Initially, Firm 1’s MC is zero, while Firm 2’s MC is
$4,000, so there is a strong incentive for Firm 2 to purchase permits from Firm 1.
Trading should continue until MC1 = MC2, which is the cost-effective solution.
This means that the market price for permits will equal $3,000, the same as the
emissions fee. At this price, Firm 2 will purchase 10 permits from Firm 2, allowing
Firm 2 to reduce emissions by 30 rather than 40 and requiring Firm 1 to reduce
emissions by 10. This solution is the same as the solution achieved with the

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 Chapter 5 - Externalities

emissions fee. However, Firm 1 is better off because instead of having to pay taxes,
it will receive a payment of $30,000 for its permits. Firm 2 must pay $30,000 for
the extra permits, but it also avoids the payment of taxes. The government lost
$420,000 in tax revenue. The firms must still pay the cost of emissions reduction,
plus Firm 2 must pay for the permits purchased from Firm 1.

14. If marginal costs turn out to be lower than anticipated, cap-and-trade achieves too little
pollution reduction and an emissions fee achieves too much pollution reduction. With an
inelastic marginal social benefit function, cap-and-trade is not too bad from an efficiency
standpoint, while an emissions fee causes pollution reduction to be much greater than the
efficient level when marginal cost is lower than anticipated. When marginal social benefits
are elastic, the opposite is true.

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