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Negative Externality and Corrective Taxes Module

  1. Module Overview and Objectives

    This is a 35-minute module that introduces students to negative externalities and corrective taxes as a solution. This module has the following learning objectives:

    • Show students that, absent intervention, a competitive market with negative externalities leads to an inefficient number of transactions (too many transactions).
    • When taxation equals the per-unit social cost of the negative externality this leads to the efficient number of transactions.

    This module is built for classes below 100 students. For classes of 100 students or more we recommend increasing the market size to 20 students per market. This will alter the equilibrium predictions and the instruction comprehension questions.

  2. The Module: A Brief Summary

    MobLab divides students into 12-person markets (6 buyers, 6 sellers) in each of the three sessions in this module (one for practice and two for real). In every round of trading, a seller can sell—one at a time—up to three “Robot Dogs”, and a buyer can buy—one at a time—up to three “Robot Dogs”. The value of a Robot Dog to a buyer decreases across his three units, while the seller’s cost increases across her three units. While these canines have many great qualities their barking creates a nuisance cost to the community of $2.40 per dog transacted. This per-dog nuisance cost reduces each person’s payoff by 20 cents.

    In the absence of externalities a seller with Seller Cost $C who sells an Robot Dog for price $P earns a payoff of $P – $C, and a buyer with Buyer Value $V who buys a Robot Dog at price $P will get profits of $V – $P. A student’s payoff for the round is the summation of her payoffs from each of her transactions. However, in this setting there are externalities. Therefore, the total payoff will be the sum of surplus from all transactions minus the nuisance cost. This nuisance cost is $2.40 per dog and is shared equally by all 12 market participants. Therefore, Q*($2.40/12)= Q*($0.20). Without intervention equilibrium price is $3.64 and there are 15 units transacted. With a per-unit tax equal to the social cost ($2.40) the equilibrium price is $5.27 and there are 7 units transacted.

    Module Procedures in Brief

    • Run the Open Session for Students Survey
    • Have students login
    • [Minutes 0-5] Review instructions, ideally by projecting the video instructions.
    • [Minutes 5-8] Run the Instruction Comprehension Survey
    • [Minutes 8-11] Run the Practice Round Game
    • [Minutes 11-16] Run the Two-Round Game without Intervention
    • [Minutes 16-19] Reflection Survey
    • [Minutes 19-24] Review the Results
    • [Minutes 24-29] Run the Two-Round Game with Corrective Tax
    • [Minutes 29-32] Review the Results
    • [Minutes 32-35] Run the Final Reflection Survey
    • [Variable] Open Discussion
    • [Variable] MobLab Experience Survey
      • At the end of the module please administer our MobLab Experience Survey. You can set the game duration to be 24 hours which allows students ample time to complete the survey outside of class.
  3. Procedures

    • [Before class] Log in to MobLab. In the left panel, create a Playlist, giving it a name students will find informative. In the right panel, expand this module and click Add.
    • [Shortly before class] Run the Open Session for Students Survey. While this survey has no actual questions (only a waiting message), running it before class ensures that students logging into MobLab will be able to access this session (playlist) immediately.
      • With the Open Session for Students survey expanded, click Run Survey followed by Begin the Game.
    • [As students are entering] Have all students log in to MobLab, either with the app on their mobile devices or in a browser (moblab.com).
    • [5 minutes] Review the instructions with students
      • Expand the first game and click Instructions. If your classroom has audio capabilities, we recommend clicking Video Instructions in the resulting popup.
    • [3 minutes] Run the Instruction Comprehension Survey.
      • You may need to finish the Open Session for Students survey before starting the Instruction Comprehension survey.
      • The survey reviews the market mechanism, how each individual’s share of the nuisance cost is calculated, and asks students their payment under two scenarios.
      • Question 1: Rules Review (no answer)
      • Question 2: Question about nuisance cost. Answer: (c) $0.20
      • Question 3: Hypothetical buyer payoff. Answer: (c) $1.50
      • Question 4: Hypothetical seller payoff: Answer: (d) $0.50
      • Work through the questions with your students.
      • Ask if they have any questions.
    • [3 minutes] Run the Practice Round Run Game. This is a single two minute and thirty second round game to help students familiarize themselves with the game interface.
      • While this game's payoffs do not count towards points earned in the course, point out that subsequent games will repeat this market, so sincere play in this round will help them in future games.
      • After pressing Run Game and then Begin the Game! in the resulting popup, the game will start on student screens, and your screen will switch to the game monitor.
      • After approximately 45 seconds, click Add Robots (if the final group contains fewer than 10 students).
      • When the final market has finished the round, click Finish to end the game.
      • Ask if students have any questions about rules or procedures.
    • [5 minutes] Run the Two-Round Game. Each round will last two minutes.
      • Inform students that costs and values from the practice round will be the costs and values in each round of the current game.
      • Inform students that their role may change from the practice round, but will remain the same in each round of the current game.
      • Approximately 20 seconds after starting this game, click Add Robots (if the final group contains fewer than 10 students).
      • When the final market has finished the second round, click Finish to end the game.
    • [3 minutes] Run Reflection Survey
      • Question 1: What were your considerations in buying or selling robot dogs?
      • Question 2: How would your considerations be different if you thought about aggregate transactions at the community level?
      • Discuss the premise of the questions:
        • In Question 1 you should describe your actions and the thought process that led you to take those actions.
        • In Question 2 think not only about your own actions but the actions of every other person in the market. How do all those actions hang together and what are the implications for economic welfare?
      • If you award participation marks for MobLab performance, we recommend awarding full credit for any thoughtful response.
    • [5 minutes] Discuss Results
      • Click Results.
      • At first, focus attention on the top 2 graphs: group 1’s supply and demand graph and its transactions graph. Typical results are shown in Figure 1 below.
      (Graph Coming Soon!)

      (Figure 1: Typical Market Results with Negative Externalities. Click to expand)

      • Using the checkboxes in the legends for these two graphs, hide all of the lines.
      • Reveal the market demand line. Explain that it shows the 18 robot dog values (6 buyers each demanding 3 robot dogs) in each market, ordered from highest to lowest.
      • Reveal the market supply line. Explain that it shows the 18 robot dog cost (6 sellers each supplying 3 robot dogs) in each market, ordered from lowest to highest.
      • Reveal the equilibrium price line.
      • Reveal the supply line that accounts for external costs. Explain that for every robot dog supplied there was a $2.40 cost imposed on the community. Sellers are only accounting for a small fraction of this nuisance cost in their production ($.20).
      • Reveal the adjusted equilibrium price line when negative externalities are taken into account.
      • Reveal the transaction markers. While you should expect some variation in transaction prices, transactions will generally be loosely clustered around the equilibrium prediction that does not adjust for externalities.
        • Tie this back to their responses to Question 1 in the Reflection Survey. The price at $3.64 is much lower than the $5.27 price if external costs were taken into account. Probe students about why they were not willing to pay $5.27.
        • Ask students about Question 2. How did they answer the question about economic welfare? Students should be able to articulate that some transactions happened where more costs were incurred than benefits derived.
        • Point out to students that in a market without externalities each individual pursuing their own interest maximized general welfare i.e. surplus. However, with externalities pursuit of own interest leads to over-provision.
    • [5 minutes] Run the Two-Round Game with Corrective Taxes. Each round will last two minutes.
      • Inform students that in this round there will be a tax imposed on sellers of robot dogs. This tax is exactly equal to the community nuisance cost $2.40 and changes the way sellers calculate profits $P - $C - $2.40.
      • Inform students that their role may change from the practice round, but will remain the same in each round of the current game.
      • Approximately 20 seconds after starting this game, click Add Robots (if the final group contains fewer than 10 students).
      • When the final market has finished the second round, click Finish to end the game.
    • [3 minutes] Discuss Results
      • Click Results.
      • At first, focus attention on the top 2 graphs: group 1’s supply and demand graph and its transactions graph. Typical results are shown in Figure 2 below.
      (Graph Coming Soon!)

      (Figure 2: Typical Market Results with Negative Externalities and Corrective Tax Click to expand)

      • Using the checkboxes in the legends for these two graphs, hide all of the lines.
      • Reveal the market demand line. Explain that it shows the 18 robot dog values (6 buyers each demanding 3 robot dogs) in each market, ordered from highest to lowest.
      • Reveal the market supply line. Explain that it shows the 18 robot dog cost (6 sellers each supplying 3 robot dogs) in each market, ordered from lowest to highest.
      • Reveal the equilibrium price line.
      • Reveal the supply line that accounts for external costs. Explain that for every robot dog supplied there was a $2.40 cost imposed on the community.
      • Remind students that in the previous game suppliers did not account for the full $2.40 cost to the community; however, in this game the tax increased seller minimum willingness to accept by $2.40 for each unit. This is exactly the size of the cost to the community.
      • Reveal the adjusted equilibrium price line when negative externalities are taken into account.
      • Reveal the transaction markers. While you should expect some variation in transaction prices, transactions will generally be loosely clustered around the tax adjusted equilibrium prediction.
      • Point out that this higher price implies much fewer transactions would take place and therefore approaches the optimal solution.
    • [3 Minutes] Run Final Reflection Survey
      • Question 1: These corrective taxes are sometimes called, "Pigouvian Taxes" after economist Arthur Pigou who advanced the idea. In his book, The Economics of Welfare, he was skeptical that ideal solutions could be implemented because, "authorities are liable to ignorance, sectional pressure, and personal corruption". What does he mean by “liable to ignorance” and “sectional pressure”?
      • Discuss the premise of the questions:
        • In this question I want you to think through the process of how you would determine what the size of the tax would be. I also want you to think about who is implementing the taxes and the incentives of those individuals.
      • If you award participation marks for MobLab performance, we recommend awarding full credit for any thoughtful response.
    • [Variable] Open Discussion
      • Ask if students have any questions.
      • This game can open up significant discussion about the prevalence of externalities the real welfare losses that occur from them but also the difficulty in implementing the textbook solution.
      • For the final reflection question:
        • “Liable to ignorance” is about knowledge. Probe students about how we obtain information about price and how this differs for nuisance cost to the community (e.g. market prices v. contingent valuation, hedonic pricing of attributes, etc.). What happens if we implement the tax having misjudged the magnitude of the negative externality?
        • “Sectional pressure” is about incentives. Probe students to articulate the implications of the fact that political agents likely act in their own self-interest. What is in their self-interest? Re-election, increasing the discretion of their organization, etc.? To what extent are these aligned or conflicting with the implementation of the correct tax? To what extent is Pigou's skepticism warranted?