Chapter 5 - Externalities

state and local finance

state finacnes - sales and excise taxes - state income taxes - corporate income tax licenses fees and state run lotteries State: 2 biggest spendings Education and Public welfare Local: 2 biggest spendings: Education and Public welfare

cost-benefit analysis

A comparison of the marginal costs of a government project or program with the marginal benefits to decide whether or not to employ resources in that project or program and to what extent.

Public Good

A good or service that is characterized by nonrivalry and nonexcludability; a good or service with these characteristics provided by government.

Private Good

A good or service that is individually consumed and that can be profitably provided by privately owned firms because they can exclude nonpayers from receiving the benefits.

quasi-public goods

A good or service to which excludability could apply but that has such a large spillover benefit that government sponsors its production to prevent an underallocation of resources.

LO5.1 Differentiate between demand-side market failures and supply-side market failures.

A market failure happens in a particular market when the market produces an equilibrium level of output that either overallocates or underallocates resources to the product being traded in the market. In competitive markets that feature many buyers and many sellers, market failures can be divided into two types: Demand-side market failures occur when demand curves do not reflect consumers' full willingness to pay; supply-side market failures occur when supply curves do not reflect all production costs, including those that may be borne by third parties. Properly functioning competitive markets ensure that private goods are (a) available, (b) produced in the least costly way, and (c) produced and sold in the "right" amounts.

Pigouvian Tax

A tax or charge levied on the production of a product that generates negative externalities. If set correctly, the tax will precisely offset the overallocation (overproduction) generated by the negative externality.

regressive tax

A tax whose average tax rate decreases as the taxpayer's income increases and increases as the taxpayer's income decreases.

Progressive Tax

A tax whose average tax rate increases as the taxpayer's income increases and decreases as the taxpayer's income decreases.

proportional tax

A tax whose average tax rate remains constant as the taxpayer's income increases or decreases.

Average tax rate

Total tax paid divided by total (taxable) income, as a percentage.

demand-side market failures

Underallocations of resources that occur when private demand curves understate consumers' full willingness to pay for a good or service. impossible to charge consumers what they are willing to pay for the products some can enjoy benefits w/o paying

allocative efficiency

The apportionment of resources among firms and industries to obtain the production of the products most wanted by society (consumers); the output of each product at which its marginal cost and price or marginal benefit are equal. when achieved no shortage or surplus in market

local finances

property taxes sales taxes and excises taxes income taxes

Consumer Surplus (CS)

the monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the good actually costs perfect compettive market consumer pay equillibroum price

Net taxes are

the net amount paid by the private sector to the government

Producer Surplus (PS)

the difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good

optimal reduction of an externality

The reduction of a negative externality such as pollution to a level at which the marginal benefit and marginal cost of reduction are equal.

LO5.4 Describe the differences between the benefits-received and ability-to-pay principles of taxation.

Government reallocates resources from the private sector to the public sector through taxation, which decreases after-tax income and therefore reduces the demand for private goods. Government then uses the tax revenues to finance the provision of public goods and quasi-public goods. The benefits-received principle of taxation states that those who receive the benefits of goods and services provided by government should pay the taxes required to finance them. The ability-to-pay principle states that those who have greater income should be taxed more, absolutely and relatively, than those who have less income.

LO5.3 Explain how positive and negative externalities cause under- and overallocations of resources, and how they might be corrected.

Externalities cause the output of certain goods to vary from society's optimal output. Negative externalities (spillover costs) result in an overallocation of resources to a particular product. Positive externalities (spillover benefits) are accompanied by an underallocation of resources to a particular product. Direct controls and Pigovian taxes can improve resource allocation in situations where negative externalities affect many people and community resources. Both direct controls (for example, smokestack emission standards) and Pigovian taxes (for example, taxes on firms producing toxic chemicals) increase production costs and hence product price. As product price rises, the externality and overallocation of resources are reduced because less of the output is produced. Government can correct the underallocation of resources in a particular market either by subsidizing consumers (which increases market demand) or by subsidizing producers (which increases market supply). Such subsidies increase the equilibrium output, reducing or eliminating the positive externality and consequent underallocation of resources. The Coase theorem suggests that under the right circumstances private bargaining can solve externality problems. Thus, government intervention is not always needed to deal with externality problems. The socially optimal amount of externality abatement occurs where society's marginal cost and marginal benefit of reducing the externality are equal. With pollution, for example, this optimal amount of pollution abatement is likely to be less than a 100 percent reduction. Changes in technology or changes in society's attitudes toward pollution can affect the optimal amount of pollution abatement.

Supply-Side market Failures

Overallocations of resources that occur when private supply curves understate the full cost of producing a good or service. occurs when a firm does not pau the full cost of producing its output external costs of producing the good are not reflected in the supply ex. chemical company dumps chemicals while not getting charged, the river pollution destroys farmer crops and they pay the price and other companies pay for the cleanup

Federal Taxes

Personal income tax progressive tax marginal tax payroll tax corporate income tax exise tax A tax levied by the United States Internal Revenue Service (IRS) on the annual earnings of individuals, corporations, trusts and other legal entities.

LO5.2 Identify how public goods are distinguished from private goods, and explain the method for determining the optimal quantity of a public good.

Public goods are distinguished from private goods. Private goods are characterized by rivalry (in consumption) and excludability. One person's purchase and consumption of a private good precludes others from also buying and consuming it. Producers can exclude nonpayers (free riders) from receiving the benefits. In contrast, public goods are characterized by nonrivalry (in consumption) and nonexcludability. Public goods are not profitable to private firms because nonpayers (free riders) can obtain and consume those goods without paying. Government can, however, provide desirable public goods, financing them through taxation. The collective demand schedule for a particular public good is found by summing the prices that each individual is willing to pay for an additional unit. The optimal quantity of a public good occurs where the society's willingness to pay for the last unit—the marginal benefit of the good—equals the marginal cost of the good.

Positive Externalities

Spillover production or consumption benefits conferred on third parties without compensation from them. external benefit under production 3rd party is getting benefit even though they didn't purchase or aquire the good or service ex; immunization people pay for the vaccine and herd immunity is developed, but then there are people who are "immune" due to herd immunity but never got or paid for vaccine gov might fix using subsidies to consumers, subsidy to producers

negative externalities

Spillover production or consumption costs imposed on third parties without compensation to them. 3rd party who is not using the product has to pay the cost external cost over production not fully paying their cost and tend to over allocate

LO5.5 Distinguish between proportional, progressive, and regressive taxes.

The federal income tax is progressive (average tax rate rises as income rises). The corporate income tax is roughly proportional (average tax rate remains constant as income rises). General sales, excise, payroll, and property taxes are regressive (average tax rate falls as income rises). Overall, the U.S. tax system is slightly progressive. Market failures present government with opportunities to improve the allocation of society's resources and thereby enhance society's total well-being. But even when government correctly identifies the existence and cause of a market failure, political pressures may make it difficult or impossible for government officials to implement a proper solution.

ability to pay principle

The idea that those who have greater income (or wealth) should pay a greater proportion of it as taxes than those who have less income (or wealth).

Benefits Received principle

The idea that those who receive the benefits of goods and services provided by government should pay the taxes required to finance them. ex; gasoline tax, fund highway construction and repair so make it if you drive you pay for the roads difficult to determine who benefits if services are from public goods education national defense etc cannot apply to income redistribution program

Coase Theorem

The idea, first stated by economist Ronald Coase, that externality problems may be resolved through private negotiations of the affected parties.

Market Failures

The inability of a market to bring about the allocation of resources that best satisfies the wants of society; in particular, the overallocation or underallocation of resources to the production of a particular good or service because of spillovers or informational problems or because markets do not provide desired public goods.

Free Rider Problem

The inability of potential providers of an economically desirable good or service to obtain payment from those who benefit because of nonexcludability.

productive efficiency

The production of a good in the least costly way; occurs when production takes place at the output at which average total cost is a minimum and marginal product per dollar's worth of input is the same for all inputs. When achieved, fully produces a per unit minimum productivity to minimize waste of resources in society

marginal tax rate

The tax rate paid on an additional dollar of income.

Externalities

economic side effects or by-products that affect an uninvolved third party; can be negative or positive market failure req. gov action

Government expenditure

governments buy goods and services from firms

Dealing with externalities

individual bargaining Gov. intervention - direct control by force - specific taxes or charge tax for CO2 emmission ex: tax on high emissions of CO2 promotes car companies to find less pollutive new tech liability rules and law suits Market based approach - market for externality rights

Government Transfer Payments

non exhaustible not directly observe, use or create part of domestic product ex; foodstamps, social security payments to persons that are not made in return for goods and services currently supplied

average tax rate formula

total taxes paid / total taxable income