2.8(3) Government intervention to manage externalities (negative)

why do governments intervene in the economy?

To correct market failure, improve resource allocation, and enhance citizens' welfare.

How do governments attempt to correct market failure?

By moving market output closer to the socially efficient level where social costs equal social benefits

What is one of the central problems for governments when trying to reduce negative externalities and achieve socially efficient output?

Measuring the external costs and determining the exact point of socially efficient output (private + external costs are minimised) is difficult.

government intervention for demerit goods

the government t reduces demand for demerit goods by:

• indirect taxes

• regulations

• demand-reducing policies (campaign, education)

Pigovian tax

type of indirect tax placed on goods or activities that create negative externalities

→ specifically used to fix market failure from externalities

What does a Pigovian tax do?

1. the government places a tax equal to the external costs

2. this increases producers costs shifting the supply curve upward/left

3. new supply curve = MSC, not just MPC

4. as a result the market output falls to the social efficient level: MSC=MSB

MPC - Marginal private costs

cost that a producer or consumer directly pays for producing/consuming one more unit of g/s

→ important as it shows the private costs not including external costs

Tax on consuming external costs

Pigovian tax specifically applied to consumer to reduce harmful consumption

what are taxes on consumption external costs and how do they fix market failure?

• taxes are used to reduce or correct negative consumption externalities

• increase the price to reflect the true social cost

• reduce overconsumption by shifting demand left

• move output (quantity of g/s produced or consumed) closer to social optimum, reduce ing welfare loss

• welfare loss is not removed completely but is reduce

How do taxes on consumption external costs affect output and welfare loss?

1. without tax, output is higher than socially optimal → causes welfare loss

2. tax raises price → reduces quantity demanded (output)

3. output move closer to social optimum reducing welfare loss

4. welfare loss is not removed completely but is reduced

Advantages of using tax

• Tax revenue can be used to compensate affected third parties and pay for an externality's negative consequences.

• Increasing the price of a good is an effective way of reducing its consumption and production

Disadvantages of using tax

• Tax can reduce the welfare of low-income groups where the price of a good is a significant proportion of their income

• Increasing business costs can lead to lower business profits and even business failure. Increasing taxes can be particularly significant for small businesses. (cannot always pass all the tax to consumers due to PED)

• can increase inflation (cost-push)

• can make domestic firms uncompetitive

• If output decreases unemployment in an industry can rise

How can taxes on energy lead to inflation?

Taxes on energy increase business costs. Since energy used in most industries, many firms raise prices to protect profit. this causes the average price level in the economy to rise, leading to cost-push inflation (reduces purchasing power)

→ cost push inflation is when APL rises in economy because the costs of production increase

How can taxes make domestic firms uncompetitive internationally?

1. taxes raise production costs for domestic firms, making their goods more expensive

2. foreign firms without this taxes can offer cheaper products

3. this makes domestic firms lose competitiveness, leading to more imports and fewer exports

Regulation of production external costs

Governments can regulate production externalities by requiring firms to meet certain criteria when they are producing goods and services.

Regulation of consumption external costs

The strictest form of regulation is to make the consumption and production of a good with significant external costs illegal

• or for some age restrictions, licensing hours, restricted consumption in public places etc. (alcohol)

Advantages of regulations

1. can directly control the specific cause of a negative externality while taxes are more general

2. can increase business costs, but are less likely to cause a price increase compared to taxes, if the firm can comply with them easily

Disadvantages of regulation

1. The cost of implementing legal restrictions can be significant for governments

2. Parallel markets arise in regulated markets and the goods provided can be in the hands of criminal gangs. (drug market)

3. Firms can find their way around regulations

4. businesses may relocate to countries with weaker regulations to cut costs. this can lead to job losses at home and shift the harmful externalities to other countries

Tradable permits

government sets a cap on total pollution and issues permits allowing firms to pollute up to a certain amount.

→ Firms can buy or sell these permits (firms that reduce pollution can sell extra permits for profit, firms that need to pollute more buy the permits)

Advantages of tradable permits:

1. encourages firms to reduce pollution in the cheapest way

2. limits total pollution to a specific cap (environmental goal)

3. provides financial incentives for innovation and cleaner production(sell permits )

Disadvantages of tradable permits

1. can be complex and costly to administer and monitor

2. risk of permits being allocated unfairly or markets manipulated

3. difficult to set the right cap and permit prices

CAP

A government-set limit on the total amount of pollution (or negative externality) allowed in an economy or industry over a certain period.

→ determines maximum

→ gov issues permits equal to cap

Reducing Demand in relation to negative externalities

Way of dealing with negative externalities is to reduce the demand for the good associated with the negative externality to the socially optimum level of output.

→ This can be done through government-financed advertising campaigns.

→ to reduce the demand for goods associated with negative externalities by subsidising products that are substitutes for the ones with negative externalities. 

Advantages of reducing demand

1. Advertising does not add to business costs so the price of goods does not increase

2. effective long-term solution to the problem as it changes consumer behaviour

Disadvantages of reducing demand

1. opportunity cost to government of paying subsidies, advertising, education. (could have been used elsewhere)

2. difficult to measure effectiveness of advertising and educational programs