Regulation and pollution permits to solve market failure

Define regulation

A rule/ law enacted by the government which economic agents must abide

Regulation is used to encourage a change in behaviour

What is needed for regulation to work effectively

Command and control

Command - The actual law or rule for example a ban on smoking or a limit on how much your car can pollute or a compulsory time at school

Control - If the command is broken the control must ensure agents are reprimanded - prison or a fine and actually caught - policing

What are the drawbacks of regulation

Opportunity cost of policing and enforcing these laws

Is the command correct - too strict, not strict enough

black market or intended consequences - banning a good may just lead to black markets forming for example America banning alcohol and betting just led to criminal organisation supplying both instead. Or firms may find loop holes to get around the regulation and cheat it

Equity - Some firms may find it extremely difficult to abide regulations while others can easily fit into the restrictions

Why are pollution permits used

Pollution permits are used to bring down pollution

What is the process of implementing pollution permits

A cap on pollution is set at Q star

Then permits are issued to firms matching this cap

Firms will then make a decision on what costs less either cutting back on their pollution or purchasing pollution permits if it is cheaper to do so

The externality is internalised either way as either the firm cuts back pollution to the social optimum or they purchase pollution permits reflecting their excessive pollution through increased costs of production

However pollution permits must be strictly enforced to stop firms from breaching their caps and then allocative efficiency will be reached

What is a major long run advantage of pollution permits

There is a huge incentive for firms to invest in green technology for the long run to decrease costs of purchasing pollution permits and even making a profit off selling spare permits

But also because permits often rise in price due to the government cutting back on permits and tightening the cap. Firms that do not have to rely on permits will save huge on costs in the long run

Draw a diagram on pollution permits

What is an issue with implementing pollution permits

Enforcing pollution permits costs lots of money but also can the government even record pollution accurately

If government has imperfect information they may set the cap badly leading to firms cheating the permits or not even needing to change their current levels of pollution

Unintended consequences - this will increase firms costs of production which could lead to black markets forming after price increases or could just lead to inflation. Or if costs are too high they may move countries or shut down

International cooperation - getting other counties to adopt similar schemes so that pollution decreases worldwide is incredibly difficult