Econ 100.

2 Microeconomics

Discussion Class
October 4, 2018
UP School of Economics

Glacer Vasquez
glacervasquez@gmail.com

10/4/18 Econ 100.2 Discussion Class   1

  
 
 
Ques&ons?  
 

10/4/18 Econ 100.2 Discussion Class   2

Reminders

Ø  Exercise  Set  No.3  due  today  

Ø  The  second  exam  is  scheduled  on  Tuesday,  October  16,  2018,  
11AM-­‐1PM  

 
 
10/4/18 Econ 100.2 Discussion Class   3
Recap

Ø  The  Effects  of  a  Tax  

Ø  The  Deadweight  Loss  
Ø  What  determines  the  size  of  DWL?  
Ø  DWL  and  Tax  Size  
Ø  Revenue  and  Tax  Size  

 
10/4/18 Econ 100.2 Discussion Class   4
Recap
P
1000

900

800

700

600
S
500

400    

300

200
D
100

0
0 50 100 150 200 250 300
Q
10/4/18 Econ 100.2 Discussion Class   5
 EXTERNALITIEs

10/4/18 Econ 100.2 Discussion Class   6

Outline

Ø  Externality  
Ø  Nega&ve  Externality  
Ø  Posi&ve  Externality  
Ø  Public  Policies  
Ø  Correc&ve  Tax  vs  Regula&on  
Ø  Regula&on  vs  Tradable  Pollu&on  Permits  
Ø  Correc&ve  Tax  vs  Tradable  Pollu&on  Permits  
Ø  Private  Solu&ons  
 

10/4/18 Econ 100.2 Discussion Class   7

Externality

•  Externality  is  the  the  uncompensated  impact  of  one  person’s  

ac&ons  on  the  well-­‐being  of  a  bystander.  
•  It  can  be  posi&ve  or  nega&ve.  
•  What  are  examples  of  nega&ve  externali&es?  
•  What  are  examples  of  posi&ve  externali&es?  

10/4/18 Econ 100.2 Discussion Class   8

Externality
P
1000
The market equilibrium maximizes
900 consumer + producer surplus.

800

700

600
S
500

PE 400

300

200 Supply curve shows private cost, the

D
costs directly incurred by sellers.
100 Demand curve shows private value,
the value to buyers.
0
0 50 100 150 200 250 300
QE Q
10/4/18 Econ 100.2 Discussion Class   9
Negative Externality
P
1000
How do we represent the negative
900 externality?

800 External cost is the value of the

negative impact on bystanders.
700 Suppose the external cost is PhP200
per unit of good Z.
600
S
500

PE 400

300

200
D
External cost
100

0
0 50 100 150 200 250 300
QE Q
10/4/18 Econ 100.2 Discussion Class   10
Negative Externality
P
1000
How do we represent the negative
900 externality?

800
Social cost
700

600
S
500

PE 400

300

200
D
External cost Social cost = private cost + external cost
100

0
0 50 100 150 200 250 300
QE Q
10/4/18 Econ 100.2 Discussion Class   11
Negative Externality
P
1000
What is the socially optimal quantity?
900

800
Social cost
700

600
S
500

PE 400

300

200
D
Q = 200?
100 Q = 100?
Q = 150?
0
0 50 100 150 200 250 300
QOptimum QE Q
10/4/18 Econ 100.2 Discussion Class   12
Negative Externality
P
1000
Compare the market equilibrium and the
900 social optimum.

800
Social cost
700

600
S
500

PE 400

300

200
D
Market equilibrium (Q = 200) is larger
100 than social optimum (Q = 150).
How do we internalize the externality?
0
0 50 100 150 200 250 300
QOptimum QE Q
10/4/18 Econ 100.2 Discussion Class   13
Negative Externality

•  How  do  we  internalize  the  nega&ve  externality?  

•  We  alter  incen&ves  so  that  people  take  into  account  the  nega&ve  
external  effects  of  their  ac&ons.  
•  One  solu&on  is  to  tax  sellers  PhP200  per  unit  of  good  Z.    
•  When  market  par&cipants  take  into  account  the  social  costs,  
then  market  equilibrium  =  social  op&mum.    

10/4/18 Econ 100.2 Discussion Class   14

Positive Externality
P
1000
How do we represent the positive
900 externality?
External benefit
800

700

600
S
500

PE 400

300

200 External benefit is the value of the

D
positive impact on bystanders.
100 Suppose the external benefit is PhP200
per unit of good Z.
0
0 50 100 150 200 250 300
QE Q
10/4/18 Econ 100.2 Discussion Class   15
Positive Externality
P
1000
How do we represent the positive
900 externality?
External benefit
800

700

600
S
500

PE 400 Social value

300

200
D
100 Social value = private value + external
benefit
0
0 50 100 150 200 250 300
QE Q
10/4/18 Econ 100.2 Discussion Class   16
Positive Externality
P
1000
What is the socially optimal quantity?
900

800

700

600
S
500

PE 400 Social value

300

200
D
Q = 200?
100 Q = 150?
Q = 250?
0
0 50 100 150 200 250 300
QE Q
QOptimum
10/4/18 Econ 100.2 Discussion Class   17
Positive Externality
P
1000
Compare the market equilibrium and the
900 social optimum.

800

700

600
S
500

PE 400 Social value

300

200
D
Market equilibrium (Q = 200) is smaller
100 than social optimum (Q = 250).
How do we internalize the externality?
0
0 50 100 150 200 250 300
QE Q
QOptimum
10/4/18 Econ 100.2 Discussion Class   18
Positive Externality

•  How  do  we  internalize  the  posi&ve  externality?  

•  We  alter  incen&ves  so  that  people  take  into  account  the  posi&ve  
external  effects  of  their  ac&ons.  
•  One  solu&on  is  to  subsidize  buyers  PhP200  per  unit  of  good  Z.  
When  market  par&cipants  take  into  account  the  social  value,  
then  market  equilibrium  =  social  op&mum.    

10/4/18 Econ 100.2 Discussion Class   19

Summary

Nega&ve  externality  
•  market  equilibrium  quan&ty  is  larger  than  socially  desirable  
•  to  internalize  the  externality,  tax  goods  with  nega&ve        
externali&es  

Posi&ve  Externality  
•  market  equilibrium  quan&ty  is  smaller  than  socially  desirable  
•  to  internalize  the  externality,  subsidize  goods  with  posi&ve  
externali&es  
 

10/4/18 Econ 100.2 Discussion Class   20

  
 
 
Ques&ons?  
 

10/4/18 Econ 100.2 Discussion Class   21

Public Policies

Command-­‐and-­‐control  policies:  Regula&on  

•  regulate  behavior  directly  

Market-­‐based  policy  1:  Correc&ve  Taxes  and  Subsidies  

Market-­‐based  policy  2:  Tradable  Pollu&on  Permits  
•  provide  incen&ves  so  that  private  decision-­‐makers  will  choose  to  
solve  the  problem  on  their  own  
 

10/4/18 Econ 100.2 Discussion Class   22

Corrective Tax vs Regulation

Correc&ve  Tax:  Pollu&on  tax  

Regula&on:  Require  all  firms  to  reduce  pollu&on  by  a  specific  
amount  
Which  solu&on  do  you  think  is  be\er?  
Efficient  outcome:  Firms  with  the  lowest  abatement  costs  reduce  
pollu&on  the  most.  
 
•  Different  firms  have  different  costs  of  pollu&on  abatement.  
•  A  pollu&on  tax  is  efficient:  
•  Firms  with  low  abatement  costs  will  reduce  pollu&on  to  reduce  
their  tax  burden.  
•  Firms  with  high  abatement  costs  have  greater  willingness  to  pay  
tax.  

10/4/18 Econ 100.2 Discussion Class   23

Corrective Tax vs Regulation

Correc&ve  taxes  are  be\er  for  the  environment:  

•  The  correc&ve  tax  gives  firms  incen&ve  to  con&nue  reducing  
pollu&on  as  long  as  the  cost  of  doing  so  is  less  than  the  tax.    
•  The  tax  gives  firms  an  incen&ve  to  adopt  it  a  cleaner  technology  
when  it  becomes  available.  
•  With  regula&on,  firms  have  no  incen&ve  for  further  reduc&on  
beyond  the  level  specified.  

10/4/18 Econ 100.2 Discussion Class   24

Regulation vs Tradable Pollution Permits

•  Suppose  Firm  A  and  Firm  B  are  coal-­‐burning  power  plants.  

•  Each  emits  40  tons  of  sulfur  dioxide  per  month.  
•  Goal:  Reduce  emissions  by  25%,  to  60  tons/month  
•  Cost  of  reducing  emissions:  PhP100/ton  for  A;  PhP200/ton  for  B.  
•  Assume  each  firm  is  issued  30  tradable  pollu&on  permits,  each  
permit  allows  one  ton  of  sulfur  dioxide  emission.  
•  Each  firm  may  use  all  its  permits  to  emit  30  tons,  may  emit  <  30  
tons  and  sell  legover  permits,  or  may  purchase  extra  permits  to  
emit  >  30  tons.    
•  Suppose  Firm  A  uses  20  permits  and  sells  10  to  Firm  B  for  PhP150  
each.  
•  Which  solu&on  do  you  think  is  less  costly?  Regula&on  or  tradable  
permits?  

10/4/18 Econ 100.2 Discussion Class   25

Regulation vs Tradable Pollution Permits

•  A  tradable  pollu&on  permits  system  reduces  pollu&on  at  lower  

cost  than  regula&on.        
•  Firms  with  low  cost  of  reducing  pollu&on  sell  whatever  permits  
they  can.  
•  Firms  with  high  cost  of  reducing  pollu&on  buy  permits.      
•  Pollu&on  reduc&on  is  concentrated  among  those  firms  with  
lowest  costs.      

10/4/18 Econ 100.2 Discussion Class   26

Corrective Tax vs Tradable Pollution Permits
1000
Price of pollution
Corrective Tax
900

800

700

600

500

400 Corrective Tax

300
Demand for
200 A corrective tax sets the price of pollution rights
pollution which, together with the
100 demand curve, determines the quantity
of pollution.
0
0 50 100 150 200 250 300
Quantity of pollution
Q
10/4/18 Econ 100.2 Discussion Class   27
Corrective Tax vs Tradable Pollution Permits
1000
Price of pollution
Pollution Permit
900

800 Supply of
Pollution Permits
700

600

500

P 400

300
Demand for
200 Pollution permits set the quantity of pollution rights
pollution which, together with the
100 demand curve, determines the price of
pollution.
0
0 50 100 150 200 250 300
Quantity of pollution

10/4/18 Econ 100.2 Discussion Class   28

Corrective Tax vs Tradable Pollution Permits

•  A  correc&ve  tax  raises  the  price  of  pollu&ng  and  thus  reduces  the  
quan&ty  of  pollu&on  firms  demand.    
•  A  tradable  permits  system  restricts  the  supply  of  pollu&on  rights,  
has  the  same  effect  as  the  tax.  
•  When  policymakers  do  not  know  the  posi&on  of  this  demand  
curve,  which  public  policy  achieves  reduc&on  targets  more  
precisely?    
•  The  tradable  pollu&on  permits  system  achieves  pollu&on  
reduc&on  targets  more  precisely.      

10/4/18 Econ 100.2 Discussion Class   29

Private Solutions

Types  of  private  solu&ons:  

•  moral  codes  and  social  sanc&ons  
•  chari&es  
•  business  integra&on  
•  contracts  between  market  par&cipants  and  the  affected  
bystanders  
 
 
 

10/4/18 Econ 100.2 Discussion Class   30

Private Solutions

The  Coase  Theorem  

If  private  par+es  can  costlessly  bargain  over  the  alloca+on  of  
resources,  they  can  solve  the  externali+es  problem  on  their  own.  
 
•  Assume  that  Person  A  owns  a  loud  talking  parrot.  The  parrot  talks  
loudly  and  disturbs  Person  A’s  neighbor,  Person  B.  
•  Person  A  derives  a  benefit  from  owning  the  parrot,  but  the  parrot  
generates  a  nega&ve  externality  to  Person  B.  
•  What  must  be  done?    
•  Should  the  parrot  stay?  
•  Should  it  say  good-­‐bye?  
 
 

10/4/18 Econ 100.2 Discussion Class   31

Private Solutions
Scenario  1   Scenario  2   Scenario  3  
Person  A  has  right  to  keep  the   Person  A  has  right  to  keep  the   Person  B  has  right  to  peace  and  
parrot   parrot   quiet  
Benefit  to  A  from  P:  PhP500   Benefit  to  A  from  P:  PhP1000   Benefit  to  A  from  P:  PhP800  
Cost  to  B  from  P:  PhP800   Cost  to  B  from  P:  PhP800   Cost  to  B  from  P:  PhP500  

Socially  efficient  outcome     Socially  efficient  outcome     Socially  efficient  outcome    

(B  >  C:  parrot  stays)   (B  >  C:  parrot  stays)   (B  >  C:  parrot  stays)  
(B  <  C:  parrot  says  goodbye)   (B  <  C:  parrot  says  goodbye)   (B  <  C:  parrot  says  goodbye)  
•  Parrot  says  goodbye   •  Parrot  stays   •  Parrot  stays  

Private  outcome   Private  outcome   Private  outcome  

•  B  pays  A  PhP600  to  get  rid   •  B  not  willing  to  pay  more   •  A  pays  B  PhP600  so  that  her  
of  parrot,  both  A  and  B  are   than  PhP800  and  A  not   parrot  can  stay.  
be\er  off.     willing  to  accept  less  than   •  Parrot  stays.  
•  Parrot  says  goodbye.   PhP1000.    
  •  Parrot  stays.    
Private  outcome  =  efficient   Private  outcome  =  efficient   Private  outcome  =  efficient  
outcome   outcome   outcome  

  The private market achieves the efficient outcome regardless of the initial distribution of rights.
10/4/18 Econ 100.2 Discussion Class   32
Private Solutions

Do  private  solu&ons  always  work?  

No,  because  in  reality,  we  face  
•  Transac&on  costs  
•  Stubbornness  
•  Coordina&on  problems  
 
 

10/4/18 Econ 100.2 Discussion Class   33

  
 
 
Ques&ons?  
 

10/4/18 Econ 100.2 Discussion Class   34

Outline

Ø  Externality  
Ø  Nega&ve  Externality  
Ø  Posi&ve  Externality  
Ø  Public  Policies  
Ø  Correc&ve  Tax  vs  Regula&on  
Ø  Regula&on  vs  Tradable  Pollu&on  Permits  
Ø  Correc&ve  Tax  vs  Tradable  Pollu&on  Permits  
Ø  Private  Solu&ons  
 

10/4/18 Econ 100.2 Discussion Class   35

Where are we now?
C. Markets and Welfare

1. Market Efficiency
2. Taxation and Efficiency

Mankiw, Chapters 7-9

Samuelson and Nordhaus, Chapter 17
Harford, Chapter 3
Landsburg, Chapter 8

D. Market Failures and Economics of the Public Sector

1. Externalities
2. Public goods

Mankiw, Chapters 10-11

Samuelson and Nordhaus, Chapter 11, 16-17
Levitt and Dubner [2009], Chapter 5
Lansburg, Chapter 9
Miller, et.al, Chapter 25 and 27

SECOND EXAMINATION
10/4/18 Econ 100.2 Discussion Class   36
What’s next?

Next:  Public  Goods  

 
 

10/4/18 Econ 100.2 Discussion Class   37

  
 
 
Thank  you  
 

10/4/18 Econ 100.2 Discussion Class   38

References
•  Mankiw, NG. Principles of Economics
•  Cronovich, R. Powerpoint slides for Principles of Economics

10/4/18 Econ 100.2 Discussion Class   39