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2._Externality - Externality Theory and Reality It is...

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Externality: Theory and Reality It is important to emphasize at the outset that the term “corrective tax” is not to be taken literally as a legal policy prescription. Just as the invisible hand of the market arrangements is more complex than a set of price-quantity point in two-dimensional graphs, the visible hand of government rules and regulations is more complex that a simple tax (or subsidy). Broadly interpreted, the term is a metaphor for rules and regulations designed to correct free market outcomes. In most instances, the regulations will have been imposed or modified in response to an economic problem that may loosely be categorized as an externality. The theoretical prescription of taxing externalities evolved from the work of British economist Arthur C. Pigou, Wealth and Welfare (1912) and The Economics of Welfare (1920). Although Pigou did propose corrective taxes and subsidies, his concerns were more broadly focused on what he called “extraordinary encouragements and restraints”. The textbook emphasizes applications in environmental economics, particularly the idea of emissions fees and markets for pollution rights. These notes are aimed more toward applications in the law. A. Corrective Taxation Under pristine conditions, a competitive equilibrium coincides with maximum economic surplus (gains from exchange), as measured by the area below the demand curve (D) and above the supply curve (S). In equilibrium (point A), the competitive price (P 1 ) induces a convergence of marginal benefits (accruing to buyers) and marginal cost (incurred by sellers). The output (Q 1 ) is ideal from the standpoint of those directly participating in the market. However, the presence of an externality implies a divergence between supply prices (marginal private cost) and marginal social cost (MSC). Whereas the theoretical supply curve is derived solely from the costs incurred by sellers, the MSC curve includes the additional costs incurred by others not directly involved in the market (e.g., the costs of pollution generated as a by-product of the production or consumption of the output). As a result, social surplus is maximized at an output of Q 2 , not Q 1 . S = Marginal Private Cost D $/Q . Negative Externality Marginal Social Cost (MSC) B A C P 2 P 1 Q 2 Q 1 Output . A' Figure 1 A Pigouvian tax (BC) internalizes a negative externality, causing industry output to be reduced from Q 1 to its efficient level of Q 2 .
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