Exam 21: Externalities in Competitive Markets

Many externalities arise from poorly defined property rights.

When set correctly, a Pigouvian tax is efficient because it is equivalent to a lump sum tax.

Whether or not production is accompanied by an externality, a social planner who aims to maximize social surplus will always produce (assuming he does produce) where marginal social cost is equal to marginal social benefit.

Suppose you and I are identical.We put up fireworks in our adjacent backyards on a national holiday, and we can both enjoy each other's fireworks. a.Can you identify an externality? b.Can you identify any missing markets? c.Do you think we will provide more or less than the efficient number of fireworks? d.If we could vote on a tax to be imposed on us fund fireworks in our back yards, would we vote for a lump sum tax (imposed equally on both of us) that will cause more fireworks to be put up than what we would put up on our own? e.Suppose instead the government implements a Pigouvian subsidy.How would the number of fireworks compare to what would happen in (d)? How much of a subsidy would you think we would both get for every dollar of fireworks each of us individually buys?

Transaction costs are the costs incurred by individuals dealing with one another.

It the marginal social benefit from contributions to charities is the same for all individuals who give to charities, then allowing individuals to deduct charitable contributions from their income taxes cannot serve as a Pigouvian subsidy under a progressive income tax system.

If the government does not know the efficient level of a Pigouvian tax to correct for a negative production externality, efficiency will still be enhanced so long as the government imposes a per-unit tax.

If a positive externality is caused by producers, a Pigouvian subsidy would have to be given to producers; and if a positive externality is caused by consumers, a Pigouvian subsidy would have to given to consumers.

Explain why many fishermen on a commonly owned lake continue to fish until the revenue from the average catch is equal to the marginal cost of fishing -- and why the same is not true for a firm that employs fishermen to fish on a privately owned lake.

The more price elastic the demand curve, the more a competitive market will over-produce (relative to the efficient level) in the presence of a negative externality.

In order for a Pigouvian subsidy to be efficient, the amount it costs the government to implement the subsidy must be less than the economic value of the additional externality benefits created by the subsidy.

One condition for the first welfare theorem to hold is that there are no externalities.Can this condition be re-phrased as "all property rights have been established"? And how does this justify a wide range of what we see government doing?

According to the Coase Theorem, so long as property rights are established and transactions costs are low, plaintiffs in court cases involving externalities will not care which way a judge decides.

In order for a Pigouvian tax to be efficient, the amount of revenue raised plus the economic value of the reduction in pollution must together be larger than the loss in consumer and producer surplus.

The Coase Theorem implies that the reason people sue each other in court is that transactions costs are too high.

Explain how any cap-and-trade system can be made to be equivalent to a pollution tax and vice versa.

To implement an efficient Pigouvian tax in a competitive market that has negative production externalities, the government would need to know the shape of the entire social marginal cost curve.

Explain how a pollution tax is different from a Pigouvian tax.Discuss how incentives for firms differ under the two types of taxes, and what would be required of the government if it were to structure a Pigouvian tax system to mimic the effects of a pollution tax.

Regardless of whether a negative externality is emitted by consumers or by producers, a Pigouvian tax can be imposed on consumers only.

In the absence of the negative externality from each individual's contribution to road congestion, roads would not be congested (aside from congestion caused by accidents).