Okay, so in our last presentation we
talked about externalities. How they have
the potential to have a market mess-up and
not get to MSB equals MSC.  Now if people
can privately bargain,  and there's low
transactions costs, people are reasonable,
then it's possible that the Coase
theorem finds a way out of this problem...
But in reality, lots of times
transaction costs are not very low,
people aren't reasonable, and it's
incredibly difficult to actually get
decent information about costs and
benefits to be shared across lots of
folks.  So let's talk about ways in which
the government can take an active role
in correcting market failures, and I'm
going to highlight the most popular one
for you, which is pigouvian taxes and
subsidies.  In essence the government is
going to impose a tax to fix negative
externalities and they're going to
impose a subsidy to fix positive
externalities. Okay, let's jump in... for
those of you who are keeping track here
this is chapter 5 and this will be part
2. Okay so with the negative externality
we know that the problem that we have is
that the marginal costs are not
indicative of the overall social cost
that society is going to experience.  So you've
got it add on your external costs on top
of your private marginal costs in order
to reach a marginal social cost that's
actually reflective of what the real
costs are for any individual unit of
output.  Now let's assume that there's no
positive externality, so our demand curve
actually is going to be just fine.
It will be a reflection of our marginal
social benefit in this case,
because there is no positive externality
no adjustment is needed. Now if individual buyers and sellers were to act on their own
private marginal costs and marginal
benefits, then they're going to end up at
an equilibrium-- and this equilibrium
would be represented by the intersection
of supply and demand, just like we've
seen so many chapters before.  This is
what we're going to refer to as Q
market. Q market has got a problem,
because Q market is essentially going
to produce a benefit which is much
smaller than the social costs of
creating that same unit of output...
So with MSC bigger than MSB... this is
no good for us.  This is an inefficient
outcome, and your textbook has been
describing this triangle here in yellow
as deadweight loss.  In essence every
single unit beyond the intersection of
MSC and MSB shouldn't have been made. 
They all had higher marginal social
costs than marginal social benefits.  The
trick here then, of course, is that we
want to get two MSC equalling MSB... This
is our golden rule.. well that occurs here...
and we would like to produce this
optimal level of output, this efficient
level of output.  But the question is how
do we get that to happen... in order to get
that to happen we need to make sure that
people are actually using or producing/
consuming less of whatever this object
is.  Let me give you an example at this
point.  We might be talking about
livestock and livestock as we're out
there buying and selling livestock and
keeping them ..they actually are very very
flatulent.  They fart a lot, and it seems
like a silly problem to have.. it's
stinky,  it's gross for those that are
around them, and perhaps more importantly
that fart is essentially methane.  It is a
gas which is incredibly bad from a
greenhouse gas perspective.  It traps all
kinds of heat, so it's going to
exacerbate our already ongoing issues
with global warming and climate change.
So really we need to get the amount of
livestock down  from Q market to Q optimal.
And how might we do that?  Well I already
sort of gave it away, but a pigouvian tax is
going to be implemented,  and this tax is
going to be equal to the spillover costs
or the negative externality.  So if you
set a tax equal to this spillover damage
here, then what you end up with is...you
drive up the price for consumers
compared to the old equilibrium and you
drive down the price for producers
compared to the old equilibrium.  Of
course higher
consumer prices means they'll want less
of the object and lower producer take- home
prices meaning that they're going
to want to produce less... of course that
was our whole point-- right??  We were trying to make sure that we got down here to
this Q optimal.  By imposing a tax we
essentially forced the market to an
efficient level of output where MSC is
actually going to be equal to MSB.  That's
how you could use a tax to fix a
negative externality.  Okay so what
happens when we've got a positive
externality.  Well a positive externality
we've got the opposite problem.  We've
essentially got an inefficiently low
level of output,  if you leave the market
to its own devices.  So with a positive
externality, whatever we're talking about
here, let's say that it's pertussis
vaccinations 
(whooping cough you might know it as).
Pertussis vaccinations have a spillover
benefit, because whenever anyone goes out
and gets one they're not going to get
whooping cough and people around them
are also not going to get whooping cough. 
So we're going to need to raise up our
MSB by the added benefit of any of these
units of output to society.  Now we'll
assume there are no negative spillover
costs and essentially our supply curve
our marginal cost curve is actually
going to be equal to marginal social
costs...
there are no spillover benefits there's
no adjustment that needs to be made.  Now the market by itself is going to go to
where supply equals demand, and that is
going to produce Q market.... and it will
give us our original equilibrium price. 
This is woefully inadequate though,
because of course at this quantity we
can see that what we've produced here is --
this is our marginal social cost but it
is actually much much smaller than our
marginal social benefit ---so the last
pertussis vaccination that was sold had
a much higher MSB than it did an MSc. 
This of course is also no good for us
and inefficient. Your textbook has been
talking about this area here as
essentially inefficient outcome or
deadweight loss. It's basically an area
that we should be grabbing for consumers
and producers because between this Q
market and where we're going to want to
end up, which is our Q optimal, all of
these units had higher MSBs than MSCs.  In other words, we should have kept going.. we
should have kept creating more pertussis
vaccination and we would have found that
we were actually becoming more and
more efficient.  So how do we do that? This
is going to require you to think a
little bit outside of the box, hopefully
not too far.  What I'm going to want you
to do is think about a subsidy as
essentially a negative tax.  Instead of
the government taking money out the
government is actually offering to put
money in.  So if you buy something they
may give money to the producer or they may give money to the
consumer.   Of course in order to get any
more output created they're going to
have to share that money because you
have to find both willing buyers and
sellers.   Point being though,  is you can
use the same kind of wedge analysis.   You've
just got to put the wedge on the other
side of your equilibrium.   So you're going
to impose a subsidy that's equal to your
external benefit,  or your spillover.  In
other words you're going to offer a
subsidy that's equal to the
spillover benefit generated from the
vaccinations.  Once you do this, of course
what this means is,  coming off of our
original supply curve.... we know that this
is the price the producer is going to
get to take home now and the bottom part
of our wedge is going to give us the
price the consumer is going to actually
end up paying now after the subsidy.  Mind
you this is the exact opposite of
the tax,  because of course the money is
going in rather than coming out,  which is
why PP, or the price to the producer,  comes off
the top of a wedge for a subsidy and the
consumer's price comes off of the bottom. 
In any event, what you can see is that as
the price to the producer rises they of
course are going to be interested in
bumping up quantity, and as the cost of
vaccinations lowers for consumers they
are also going to be interested in
purchasing more quantity.  That's what's
going to get us from Q market to  Q optimal...
and with our subsidy set at the level of
the spillover benefit this is going to
push us right out to the spot where MSC
is equal to MSB.   I'm going to circle
that in red right here... we're going to
get to this intersection right there.. and
we're efficient...yay! right?.... MSC equals MSB.
The last vaccination produced social
benefits equal to the social costs on
the margin. 
Okay there you have it.  Two different
examples, one a negative and one a
positive externality.  You can essentially
fix them by imposing a tax or subsidy... 
taxes for negative externalities, because
negative externalities are generally
over produced; so we need to knock the
quantity down to the efficient level... and
subsidies for positive externalities,
because positive externalities are under
produced; and we need to Goose the
quantity up to the efficient amount.  Okay
hopefully that does it for you.  Let me
know if you have questions,  and in our third
installment we'll take up public goods
and common resources,  another common
instance of market failure.
