Module 7.5 Public Soultions to Externalities Lecture

Government Intervention in Externalities

Overview

• When private solutions to externalities are not feasible, government intervention is necessary.

• There are two broad approaches for government actions: Command and Control Policies, and Market-Based Policies.

Command and Control Policies

• Definition: Direct regulation of resource allocation by the government.

• Application: Commonly used for environmental regulations (e.g., specifying required pollution reduction technologies for factories).

• Challenges:

  • Governments may lack complete information about the most efficient methods to achieve pollution reduction.

  • Focus on specific technologies, not on the ultimate goal (reducing pollution).

  • Producers lack incentives to innovate or find more efficient methods since they are mandated to use specified technologies.

• When It Works:

  • In cases where high compliance is needed for success (e.g., vaccination for diseases, which has positive externalities):

    • Vaccination not only benefits the individual but also contributes to herd immunity.

    • Command and control can ensure broad compliance necessary to effectively control a disease.

Market-Based Policies

• Definition: Government provides incentives to internalize externalities.

• Corrective Tax:

  • Proposed by economist A.C. Pigou in the 1920s.

  • A tax equivalent to the externality amount that aims to lead to an efficient outcome.

  • Involves assessing the external cost to get the desired social optimal consumption level.

Example: The Loud Music Scenario

• Situation:

  • Your roommate plays loud music for six hours, treating the marginal cost and benefits from only their perspective, ignoring external damages.

• Analysis:

  • Marginal private benefit and cost curve versus marginal social cost curve, which includes external costs.

  • The goal is to shift from private equilibrium (6 hours) to social optimum (4 hours).

• Solution via Tax:

  • Implement a $6 per hour tax for loud music to internalize the externality.

  • This tax increases the marginal private cost curve to equal the marginal social cost curve, encouraging reduction in consumption to reach the social optimum.

Subsidies for Positive Externalities

• Definition: A subsidy is effectively a negative tax, incentivizing behaviors that generate positive externalities.

• Example: Handwashing:

  • Washing hands has a private benefit but also yields societal benefits (positive externalities).

  • A government subsidy for hand washing shifts the marginal private benefit upward to the marginal social benefit.

  • Result: Encourages more hand washing to shift from private equilibrium to social optimum.

Challenges in Implementation

• Valuing externalities can be complex and inaccurate, especially intangible ones (e.g., noisy neighbors).

• High administrative costs may hinder tax implementation.

• Resulting policies, such as quiet hours, may be used as a compromise solution.

• Economists working in environmental economics focus on accurately determining external costs, aiming for better efficiency than traditional command and control policies.