MarketFailure_Part1_Continued.pdf

MarketFailure_Part1_Continued.pdf - Market Failure(cont’d...

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Market Failure (cont’d) Chapters 2 & 3
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INTERNALIZATION OF EXTERNALITIES Internalization occurs when the MPC or MPB of goods/services are adjusted so that the producers or consumers consider the actual MSC or MSB of their decisions. In the case of a negative externality, the MEC is added to MPC for internalization. For a positive externality, the MEB is added to MPB to internalize the externality. Internalizing an externality results in changes in prices to reflect full MSB or MSC of a good.
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A. Corrective Taxes: A Method of Internalizing Negative Externalities A corrective tax is designed to adjust the MPC so as to internalize the externality. The tax must equal the MEC to achieve this objective. In effect, a corrective tax is exactly like a charge for emitting wastes. It is designed to internalize a negative externality by making sellers of the product pay a fee equal to the MEC. Recall the previous example: Suppose a corrective tax was imposed on producers of paper to internalize their negative externality. The MEC was $10 The next Figure shows the impact of such a tax.. The corrective tax is: ! = #$%
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What will this tax do? The tax will be treated by producers as an increase in the MPC. Consequently, the supply curve shifts up from S to S’ S’ reflects the full MSC of producing paper. The increase in cost caused by the tax changes the point corresponding to the market equilibrium from A to B. The market price of paper increases to $105 per ton, and the equilibrium quantity of paper consumed declines from 5 million tons to 4.5 million tons per year. This is exactly equal to the efficient annual output. The gain in efficiency resulting from the corrective tax is represented by the triangular area BGA Tax revenues of $45 million ($10*4.5 million tons) are collected. This is represented by the area FBJH. The tax revenue collected can be used for a variety of purposes.
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Political Support for such a Corrective Tax: Note that the corrective tax will result in some groups receiving benefits at the expense of other groups bearing the costs.
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  • Spring '10
  • hyman
  • Market failure, Externality, MEC

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