Lecture%2018%20-%20Externalities%20and%20Public%20Goods%20II

Lecture%2018%20-%20Externalities%20and%20Public%20Goods%20II...

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1 FIN 501 Financial Economics Lecture 20 – Externalities and Public  Goods II Professor Nolan Miller
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Announcements Problem Set #6 is due Tuesday. Tuesday: Review (time for your questions) Thursday, Oct. 28: Midterm MSFE: 8am – 9:20, Wohlers 240. MSF: 7pm – 8:20. MSF1 (9:30): BIF 3007 MSF2 (12:30): BIF 3041 Last Year’s Midterm available on Compass. NM Office Hours: Wednesday, 1:00 – 4:00.
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Road Map Externalities: Taxation Market Making Time Permitting: Public Goods Basic Problem Solutions
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4 Where we left off … Externalities: One actor’s action directly affects the utility of another actor. In the case of a negative externality, the market will tend to produce too  much of the good. In the event of this type of “market failure,” government policy has the  potential to lead to Pareto Improvement. Quotas: Limit production of the externality by law. Centralized: government has to understand costs, benefits to set right quota,  has to enforce.
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5 “Pigouvian” Taxation In the case of a negative externality, the market produces too much. So, the government wants people to do less. When you tax something, it increases the cost of that activity, and leads  people to engage in less of it. So, a properly chosen tax should be able to reduce x to x**. This idea is known as “Pigouvian” taxation, after Arthur Pigou, and  English economist.
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6 A pedagogical simplification To make things easier, from now on  we’ll assume that x is produced at  constant marginal cost. Once we do that, we can, “without  loss of generality” assume that MC  = 0. A positive MC would not affect the  optimal Pigouvian tax. In this case, the market quantity is  where MU 1 (x*) = 0, and the P.O.  quantity is where MU 1 (x**) +MU 2 (x**)=0. MU 1 (x) x x* MSB(x) MU 2 (x) x** “Marginal Social Benefit”
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7 Pigouvian Taxation The tax induces C1 to choose lower  x. Recall: C1 chooses x where MU(x)  = p. When p = 0, chooses x * . When p = t, chooses x t , where  MU(x t ) = t. So, what is the right level of t? MU 1 (x) x x* MU 2 (x) x** 0 t x t t **
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Pigouvian Taxation The tax should be set equal to the  cost imposed on C2 at x ** . This cost is –MU 2 (x ** ) So, set t **  = -MU 2 (x ** ), and C1 will  choose x ** . MU
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Lecture%2018%20-%20Externalities%20and%20Public%20Goods%20II...

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