Niagara University

ECO330
Dr. Tidemann

Externalities Part 2:
Government Solutions
to Negative Externalities
 Government Interventions to
Externalities
• In many cases, it may prove impossible to address
negative externalities through private bargaining:
– Inability to assign property rights
– Transactions costs are too high for bargaining

• Three forms of government policy responses to

negative externalities
– Supply regulations
– Taxes
– Subsidies
 Supply Regulations
• Government regulations could
explicitly limit production related
to the negative externality

• Niagara River example

– If the efficient level of chemical
produced is Q*, regulations could
prohibit OCC from producing above
Q*

• “Command-and-control”
approach to externalities
– With several sources of the
externality, we will discuss later why
this is the least efficient policy
approach
 Pigouvian Taxes
• The primary policy approach for addressing
externalities are Pigouvian Taxes, named after
economist A.C. Pigou

• Pigou’s insight
– Externalities arise when costs are not considered by the
source of the negative externality
– What if we tax the externality source equal to the marginal
damage at the efficient level?
– Taxes “internalize” the external cost
 Graphical Pigouvian Tax Solutions
to Negative Externalities
• Graphically, adding the tax shifts
the MPC curve upward by the
amount of marginal damages

• Niagara River Example:

– Marginal damages at Q* = cd
– Apply a tax equal to marginal
damages (cd) to each unit of
chemical produced by OCC
– Based on finding where OCC’s
MPC = MPB, OCC’s post-tax
output will drop from Q1 to Q*
 Tax Revenue from Pigouvian Taxes
• Pigouvian taxes also lead to
the collection of tax revenue

• Niagara River Example:

– OCC is paying a tax of cd units
per each unit of chemical
produced
– OCC’s tax bill = (cd)*(Q*)
– Graphically = area idcj

• Revenue could be used for

several different purposes, not
necessarily transferred to
those impacted by external
cost
 Subsidizing Reductions in
Negative Externalities
• With many government policies, there will be both a “carrot”
and a “stick” approach to promoting behavioral changes

• For externalities:
– “Stick” = taxes and regulations
– “Carrot” = subsidies

• Rather than taxing the producers of negative externalities, the

government could compensate them – via a Pigouvian subsidy
- in exchange for reducing production
 Determining the
Pigouvian Subsidy
• Government offers a per
unit subsidy:
– Equal to marginal damages at the
efficient level of output
– For each unit of reduced output
from the externality source

• Niagara River example

– OCC currently producing Q1 units
of chemical
– Government offers (cd) dollars for
each unit of chemicals it
voluntarily stops producing
– Graphically, the subsidy still shifts
the MPC curve upward by the
amount of marginal damages
 Graphical Subsidy Solutions to
Negative Externalities
• The Pigouvian subsidy adds to the
opportunity cost of selling units of
the externality-producing product
– Cost per unit = production costs +
lost subsidy

• By increasing MPC, supplier will opt

to reduce their production level

• Niagara River Example:

– Subsidy shifts MPC up to (MPC + cd)
– Based on finding where OCC’s MPC =
MPB, OCC’s post-subsidy output will
drop from Q1 to Q*
 Cost of Pigouvian Subsidies

• Pigouvian subsidies require

spending by the government to
compensate the sources of
negative externalities

• Niagara River Example:

– OCC receives a subsidy of cd
units per each unit of chemical it
stops producing (Q1 – Q*)
– OCC’s subsidy = (cd)*(Q1 – Q*)
– Graphically = area dkhc
 Comparing Pigouvian
Taxes or Subsidies
• Theoretically, there is no difference between a tax and a
subsidy in addressing the market inefficiency caused by
negative externalities
– Niagara River Example: Both reduced the amount of chemical
produced by OCC to the socially efficient level

• However, what practical considerations might be considered

in terms of which approach should be used?
– Government financing implications of subsidy/tax
– Incentives offered by either policy
– Political benefits/considerations of either policy
– Implementation challenges for either policy