Lecture Notes: Externalities and Economic Solutions

Introduction to Externalities

• External Costs/Benefits: A disconnect between private and social costs or benefits.
  • Positive Externality: External benefits enjoyed by society, not by decision-makers, leading to underproduction.
  • Negative Externality: External costs (e.g., pollution) where social marginal cost > private marginal cost, leading to overproduction.

Addressing Negative Externalities

• Internalizing Costs:
  • Taxes: Implement a tax to align private and social marginal costs.
    • Example: A coal power plant causing damage worth 10 cents per electricity unit can be taxed 10 cents per unit.
  • Impact of Taxes: Reduces supply, aligns private and social costs, and corrects overproduction.

Addressing Positive Externalities

• Incentivizing Production:
  • Subsidies: Encourage more production to align private and social benefits.
  • Similar logic as taxes but applied to positive externalities.

Pigovian Taxes and Subsidies

• Developed by Arthur C. Pigou (1920s):
  • Pigovian Taxes: Correct negative externalities.
  • Pigovian Subsidies: Correct positive externalities.

Mathematical Approach

• Marginal Costs Equations:
  • Private Marginal Cost (Supply): ( Q_s = 2P - 50 )
  • Social Marginal Cost: ( Q_s = 2P - 80 )
• Tax Calculation:
  • Set equations to unite private and social costs: ( 2P - T - 50 = 2P - 80 )
  • Solve for T: ( 2T = 30 ) → ( T = 15 )
  • Result: $15 tax realigns incentives.

Challenges of Implementation

• Complexity of Reality:
  • Measuring Harm: Disagreements on what counts as harm, long-term effects.
  • Determining Tax/Subsidy Size: Difficult to establish and adjust over time.

Market and Government Failure

• Market Failure: Inefficiencies unable to reach equilibrium on their own.
• Government Failure:
  • Causes: Human error, imperfect information, political self-interest, administrative limits, corruption.
  • Influence: Firms influencing government decisions, unintended regulatory consequences.

Summary: The lecture discussed the disconnect between private and social costs/benefits due to externalities and explored solutions like Pigovian taxes and subsidies as theoretical solutions to align these costs. However, practical challenges and potential for both market and government failure complicate their implementation.