Behavior and Choice: EC 102

This leads us to one concluding question: how can we address the discrepancy between the market outcome and what is in society’s best interest? We clearly want to incentivize activities (flu shots, education) which generate positive externalities and disincentivize activities (smoking, carbon emissions) which generate negative externalities. But how can this be done?

One tempting way of addressing an externality is directly through demand: if we can increase demand (through consumer preferences) for flu shots, or decrease demand for cigarettes, this should shift the market outcome accordingly. A marketing campaign to encourage consumers to get flu shots might be effective at shifting flu shot demand to the right, but it may take more than this to reach the social optimum. Similarly, a campaign to discourage cigarette smoking might be somewhat effective at deterring some smoking, but consumers may persist nonetheless. We likely need a more reliable policy measure for increasing or decreasing the level of activity in a market.

But as it turns out, we have two policies particularly designed to do exactly this! An excise tax is specifically designed to lower the level of activity in a market by increasing the price consumers pay and lowering the price sellers receive. This seems like the ideal policy tool to address a negative externality, since our aim is to disincentivize the activity! Similarly, a per-unit subsidy can encourage more of an activity by lowering the price consumers pay and increasing the price sellers receive, which makes it well-suited to address markets with positive externalities where society wants more of this activity!

Excise taxes and per-unit subsidies focus on prices to incentivize or disincentivize behavior. Prices are critical in integrating the social costs and benefits - typically outside the consideration of decision makers - into the decision making process itself! Often, economists refer to this as the need for individuals to internalize the externality. Recall that the main problem with externalities arises because the full benefits or costs are felt outside of the individual making the decision. But if the individual decision maker felt the impact of her decision directly, in the form of a price change, for example, she would take that impact into consideration when deciding, internalizing its full impact. The idea is to make a decision maker face a price that is a more accurate representation of the full cost or benefit of her action.

Let’s start with the market for cigarettes as an example of a negative externality. We now know that the market outcome exceeds the socially optimal outcome in this market, showing that the market will generate more transactions than is socially optimal. Our policy objective, therefore, should be to reduce the number of transactions in the market. But this is an objective the excise tax is designed to achieve! Implementing an excise tax, as we know, will simultaneously increase the price consumers pay (what we called \(P_C\)) to lower quantity demanded, and decrease the price sellers receive (\(P_S\)) to lower quantity supplied. The market will then clear when \(Q_D\) at \(P_C\) equals \(Q_S\) at \(P_S\text{.}\)

In the market for cigarettes, the original market outcome is \(q^*_{PRIV}\text{.}\) If the intended outcome is to reduce the number of transactions to \(q^*_{SOC}\text{,}\) then the excise tax should be set such that 1) the quantity demanded at \(P_C\) is \(q^*_{SOC}\) and 2) the quantity supplied at \(P_S\) is \(q^*_{SOC}\text{.}\) This way, when the market clears under the tax, the resulting number of transactions in the market is exactly the social optimum! The graph below illustrates this scenario.

Notice that the excise tax internalizes the externality for the decision makers in the market. Consumers are forced to pay a higher price for cigarettes to compensate for the added social cost of their purchase, and as a result, they lower their consumption. The higher prices forces consumers to face the full social cost of their purchase. Sellers also provide fewer units to the market, since they receive a lower price for each pack sold. Notice as well that both buyers and sellers bear some burden of the tax, implying that both groups must pay a share of the added social cost.

Rather than mandate a market outcome of \(q^*_{SOC}\) directly, the excise tax integrates the externality into the buyers’ and sellers’ decision making. Consumers and sellers must now factor in the added social cost, and when they do, the market clears at the socially optimal level.

The size of the excise tax should be exactly the size of the externality! The tax per unit should match the size of the added social cost for each unit. This makes some intuitive sense: activities which generate small social costs should be taxes moderately, while activities which generate large social costs should be taxed more heavily. By scaling the tax to the amount of social damage, policymakers can ensure decision makers factor the full costs (private \(+\) social) into their decision making.¹

In a positive externality case, such as the market for flu shots, the idea is similar but flipped! Since the market underprovides flu shots, we need to implement a policy which encourages a greater number of transactions - a per-unit subsidy. This policy lowers the price consumers pay and raises the price sellers receive, causing the market to clear at a higher quantity. A subsidy can be used to increase the number of transactions to \(q^*_{SOC}\) by subsidizing such that 1) at \(P_C\text{,}\) \(Q_D = q^*_{SOC}\text{;}\) and 2) at \(P_S\text{,}\) \(Q_S = q^*_{SOC}\text{.}\)

Since flu shots generate added benefits to society, buyers and sellers should be compensated for those added benefits. The compensation - in the form of price changes - internalizes the externality, and provides a monetary benefit to market participants. Both buyers and sellers will now be incentivized to exchange more flu shots!

By subsidizing an amount equal to the added benefit, a policymaker can appropriately incentivize buyers and sellers to integrate the externality into their decision making and shift the market outcome to the social optimum.