ECON 221 Lecture 12Outline of Last Lecture I. Tax efficiency II. Salience and Taxation III. Benefits of TaxationOutline of Current Lecture I. Overview of Externalities II. Analysis of Externalitiesa. Modeling externalities b. Solving externalities III. Government Solutions Current LectureLecture 13• Externalities o Transactions sometimes impact people other than those voluntarily buying and selling.o Ex. Production and pollution Factory producing a good, often creates pollution at the same time.- Impacts everyone, regardless of whether they’re buying or selling the goods made at this factory.- Makes everyone generally worse of From society’s perspective: polluting firms are producing too much.o Can also be divided into consumption/productiono Pollution is a negative externality – activity that harms individuals not directly involved in the transaction.o Consumption-  Cigarettes Drinking and drivingo Production- These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. Pollutiono Positive externality – activity that benefits individuals not directly involved in a transaction. o Consumption-  Vaccinations Education Charitable giving o Production-  Research and development • Analyzing externalities Remember what we are told by supply and demand curves Demand curve - comes from assessing willingness to pay, or MARGINAL BENEFITof consuming a good.- Demand curve is also a marginal benefit curve Supply curve - comes from assessing lowest willingness to accept, which is driven by MARGINAL COST- Supply curve is also a marginal cost curve Competitive markets lead to a situation where MB = MC o Marginal cost to society or “marginal social cost” (MSC) Added cost to SOCIETY (not an individual) from producing one more unit. o Marginal benefit to society or “marginal social benefit” (MSB) Added benefit to SOCIETY (not an individual) from one more unit consumed.  If we’re talking about what is best for society, “best” is the point where MSB = MSC Best point to individuals is the point where M(P)B = M(P)C where (P) = privateo Externalities either generate some additional: Marginal External Cost Marginal External Benefito Now:  MSC = M(P)C + MEC (Marginal external cost) MSB = M(P)B + MEB Marginal external benefit)o Ex. Flu shot – Positive/Production Willing to pay $2 to get a flu shot Generates $0.50 of benefit to others MB = 2, MEB = 0.50 MSB = 2.50 What does this do to our graphs? Suppose the flu shot adds $0.10 of “external benefit”- Supply curve = MC- Demand curve = MB- MSB = MB + MEB = MB + 0.10- Not a shift of the demand curve, but rather the introduction of another curve (MSB)- MSC = MC + MEC = MC + 0 = MCo Modeling externalities Negative/Consumption- Smoking- MSB = MPB – MEC  Positive/Production- Research- MSC = MPC – MEC Negative/Production- Polluting factory- MSC = MPC + MEC Note about modeling: - It if is consumption, we model it as impacting MSB - Production impacts MSC- Negative -> too much of something- Positive -> not enough Inefficiency- Fail to reach socially preferable level of activity- Negative externalities: Too much of an activity is happening- Positive externalities: Not enough of an activity is happening• Solving externalitieso Private solutionso Government solutions Positive externalities: try to get people to do more Negative externalities: try to get people to do less Internalize the externalities- o Coase Theorem o Government solutions  Pigouvian taxes - Find a way to internalize the externality and reduce production - Taxation increases marginal (private) cost- Set tax = MEC… MPC + tax = MPC + MEC = MSC Pigouvian subsides- Education may generate positive externalities o Without government, we’d have inefficiently low levels of educationso Subsidize by amount of MEB to achieve efficient outcome - What are possible externalities associated with education? o Civic participation Higher rates of voting Higher charitable giving Lower likelihood of committing crime o Is this because of education? (Or is there a third factor that causes both high education all of the other things?)o Education & voting – how might they be linked? Increased participation “Higher quality” participation o Education and productivity? Only an externality if your education afects the people around