14.41 Public Economics Section Handout #3 I. Pigouvian Tax Rosen’s explanation: “A Pigouvian tax is a tax levied on each unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the efficient level of output.” In general, this is the kind of tax that a public economist thinks about. Graphical presentation : Mathematical example (from P.S. #1, question #2b) : driving cost and the number of axels cost of gas = (1/6)*A2 (this is a private cost) pollution = (1/6)*A2 road damage = 20/A Find social optimum: Min c(A) = min ((20/A) + (1/3)*A2 + (1/6)*A2) F.O.C = -20/( A2) + (2/3)A + (1/3)A = 0 A* = 20(1/3) = 2.714 Find Pigouvian Tax (in this case a subsidy): The tax will equal the marginal damage at the socially optimal output level, A*. Tax = -20/ A*2 + (2/3)A* = -(1/3) * 20(1/3) Driver’s problem now that he/she faces the Pigouvian tax : Min ((1/6)A2 - (1/3)* 20(1/3)*A) F.O.C (1/3)A -(1/3)* 20(1/3)) = 0 A = 20(1/3) = A* The driver chooses the socially optimal level of A. II. Public Goods A. Definition - Public goods are non-rival (my consuming it does not prevent you from consuming it) and non-excludable (I can’t stop you from consuming it). Examples: national defense, lighthouse. - Optimal level of provision of private goods: each person sets MRS = ratio of prices. Firms set MRT = ratio of prices. So MRSa = MRSb = MRT (a and b are two individuals). Market demand curve is horizontal sum of individual demand curves. - Optimal level of provision of public goods: since both people are able to consume the good, its value is MRSa + MRSb. Set sum of MRS = MRT. Market demand curve is vertical sum of individual demand curves. B. Private provision of public goods - Public goods problem: can be described as a free-rider problem (you prefer to let others pay since you still enjoy the benefits) or a positive externality (your provision benefits others, but this isn’t in your utility function). The result is under provision by the private market. - To find level of private provision, use Nash bargaining (what do I want to do, holding your actions constant). This gets us reaction curves (downward sloping). C. Public Provision - If there is some private provision, what happens if government taxes you to provide some of the good? Crowdout: you reduce private provision to offset increase in public provision. - Basic principle: if you start from an individual optimum and the environment changes, if you are able to undo this change to get back to the optimum, you will. - Is there always 100% crowdout? Not if: 1) you get utility from your contributions as well as from the total (warm glow model); or 2) the government taxes some people more than they were contributing. - How much of the good to produce? Can ask people what their MRS is, then charge them that amount: Lindahl equilibrium. Problems: 1) truthful preference revelation (free rider problem); 2) people may not know their valuation; 3) too costly to determine everyone’s preferences.

14.41 Public Economics, Section Handout #3

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