Society’s resources are being used to produce the „right” quantity of the good (society has allocated the „right” amount of resources to the production of the good and producing the quantity of the good that is mostly wanted by society.

The failure of the market to achieve allocative efficiency

In reality, the free market most often fails to achieve these highly desirable results (it suggests that for markets to realise their potential, they must be supported by appropriate government policies)

Real-world situations differ from the ideal of a perfect allocation of resources 🡪 to design government policies aimed at reducing the extent of the inefficiencies

Externality

Occurs when the actions of consumers or producers give rise to negative or positive side-effects on other people who are not part of these actions, and whose interests are not taken into consideration.

Private and social benefits and costs

Marginal private cost (MPC): refer to costs to producers of producing one more unit of a good.

Marginal private benefit (MPB): refer to benefits to consumers from consuming one more unit of a good.

Marginal social cost (MSC): refer to costs to society of producing one more unit of a good.

Marginal social benefit (MSB): refer to benefits to society from consuming one more unit of a good.

If there no externalities: MPB=MPC 🡪 determine an equilibrium price and quantity that reflect a social optimum (allocative efficiency)

D=MPB=MSB and S=MPC=MSC

If there is an externality:additional benefits or additional costs affecting third parties 🡪 full benefits of full costs to society differ form the private ones 🡪 equilibrium price and quantity is no longer a social optimum (allocative inefficiency)

When MSB=MSC, there is allocative efficiency and social optimum output.

MSB= MPB+MEB and MSC=MPC+MEC

Negative production externality

External costs created by producers

Example: environmental pollution

There are additional costs for society

When the free market overallocates resources to the production of the good and too much of it is produced relative to the social optimum (at too low price)

Qm > Qopt and MSC>MSB at the point of production, Qm

There is a welfare loss (loss of social benefits due to overproduction of the good caused by the externality)

Policies to correct negative production externalities and prevent overuse of common pool resources and their evaluation

Market based policies I: indirect taxes

(Pigovian tax)

-impose an indirect tax on the firm per unit of output produced in order to correct a negative externality

-the optimal tax policy is to impose a tax that is exactly equal to the external cost

-new, after-tax equilibrium: resulting in the lower, optimal quantity of the good produced and higher, optimal price

-introduced indirect taxes are intended to lead to allocative efficiency

Policies to correct negative production externalities and prevent overuse of common pool resources and their evaluation

Market based policies II: carbon taxes

The carbon tax is a tax per unit of carbon emissions of fossil fuels (the more carbon emitted, the higher the tax).

Following the imposition of the tax, firms must pay the higher price to buy the fossil fuels 🡪 incentives for firms to switch to other, less or non-polluting energy sources

If the firm switches to alternative resources 🡪 Qopt will increase (EC will become smaller)

Reduce the size of the negative externality and increase the optimum quantity of output.

Policies to correct negative production externalities and prevent overuse of common pool resources and their evaluation

Market based policies III: tradable permits

Known as cap and trade schemes

Policy involving permits to pollute issued to firms by a government or an international body.

These permits to pollute can be traded in a market (bought and sold)

The government grants each firm a particular number of permits to produce a particular level of pollutants over a given time period.

the permits can be bought and sold, with the price of permits being determined by S and D

Permitted pollution must be less than the amount of pollution created with no permits

Incentives to producers to switch to less polluting resources for which it is not necessary to buy permits

Advantages

the effect of internalising the externality (the costs that were previously external are made internal, they are now paid by producers and consumers who are parties to the transaction

Taxation leads to lower pollution levels at a lower overall cost to society (incentives to firms to economise on the use of polluting resources and use production method that pollute less)

Incentives for firms to cut back on their pollution

Disadvantages

Uncertainty in calculating the contribution (technical difficulties)

Taxes: difficulties designing a tax equal in value to the amount of the pollution (identify: production method produce pollutants, pollutants that are harmful, the value of the harm, the appropriate amount of tax, how consumers be affected)

Carbon tax: set too low to make significant impact and firms may continuing to pollute even though they pay a tax

Tradable permits: require to set a maximum acceptable level for each type of pollutant (technical information, not available) – developed for just a few pollutants (CO2), and distribution of permits to polluting firms in a fair way (political issues)

Video – Carbon Pricing

Link: https://carbonpricingdashboard.worldbank.org/what-carbon-pricing

Understanding carbon pricing

Two main ways to price carbon

Cap-and-Trade (Quantity-Based)

The government sets a limit (cap) on how much CO₂ can be emitted.

Companies need permits to emit CO₂ and these permits can be bought, sold, or traded.

This system guarantees a specific amount of emissions reduction but can make prices unpredictable.

Carbon Tax (Price-Based)

The government adds a tax to fossil fuels when they are extracted or imported.

This makes fossil fuels more expensive, pushing companies to find cleaner energy solutions.

The price is predictable, but the exact amount of emissions reduction is uncertain.

Conclusions

Carbon pricing creates an economic reason to stop using fossil fuels.

It helps countries transition to renewable energy faster.

Every country can adapt carbon pricing to its economy, and later, these systems can be connected globally for greater impact.

Carbon pricing is one of the most powerful tools to fight climate change. If we introduce carbon pricing soon, it could lead to a cleaner and more sustainable future for everyone.

MCQs on Carbon pricing

What is the main cause of climate change?
A) Renewable energy
B) Burning fossil fuels
C) Cutting down trees
D) Recycling too much

What is carbon pricing?
A) Putting a cost on carbon emissions to make fossil fuels cheaper.
B) A method to encourage the use of fossil fuels.
C) Putting a cost on carbon emissions to reflect their real societal cost.
D) Trading renewable energy sources.

How does cap-and-trade work?
A) Companies are taxed for every ton of CO₂ will be emitted.
B) Companies are given unlimited permits to emit CO₂
C) Companies buy and trade permits that allow them to emit a limited amount of CO₂
D) The government removes all limits on emissions.

MCQs on Carbon pricing (2)

4) What is the main advantage of a carbon tax?
A) It guarantees how much CO₂ will be emitted.
B) It creates stable and predictable prices for carbon emissions.
C) It makes fossil fuels cheaper.
D) It allows companies to emit unlimited CO₂

5) Why is carbon pricing important?
A) It helps countries continue using fossil fuels.
B) It makes renewable energy more expensive.
C) It creates an economic reason to stop using fossil fuels.
D) It reduces the need for renewable energy.

6) What is the difference between cap-and-trade and a carbon tax?
A) Cap-and-trade limits emissions, while a carbon tax creates a predictable price.
B) Cap-and-trade creates a predictable price, while a carbon tax limits emissions.
C) Both allow unlimited emissions.
D) Both are methods that do not impact emissions.

MCQs on Carbon pricing (3)

7) What type of energy does carbon pricing encourage?
A) Fossil fuels
B) Nuclear energy
C) Renewable energy like solar and wind
D) Natural gas

8) What is a potential benefit of linking carbon pricing systems globally?
A) Fossil fuel prices would decrease.
B) Countries could reduce emissions more effectively.
C) CO䔖missions would stop entirely.
D) Renewable energy would become less important.

Policies to correct negative production externalities and prevent overuse of common pool resources and their evaluation

Goverment legislation and regulation:

emissions standards, quotas, licences, permits or outright restrictions

they are simple to put into effect and oversee, quite effective

do not offer incentives to reduce emissions by using less polluting resources; cost of monitoring and supervision; opportunity cost – partially correct the problem

Collective self-governance: the contribution of Elinor Ostrom

users of a common pool resources often able to find solutions on how to manage it sustainably, without overusing and destroying it (communicate, local communities, create own rules, boundary for the resource)

Policies to correct negative production externalities and prevent overuse of common pool resources and their evaluation

Education and awareness creation

provision of information makes consumers turn away from the products, with negative effects on the firm’s sales

International agreements

cooperation among governments to control and prevent negative consequences on certain resources (global climate ozone layer)

Paris Agreement: to strengthen international cooperation on climate change, emission reduction

Negative consumption externality

External costs created by consumers

Example: cigarettes and secondary smoking, cars and air pollution, loud music and noise pollution

There are „negative benefit” / reduction in benefits for society

When the free market overallocated resources to the production of the good and too much of it is produced relative to the social optimum (at too low price)

Qm > Qopt and MPB>MSB at the point of production, Qm

There is a welfare loss (loss of social benefits due to overproduction of the good caused by the externality)

Demerit goods: cigarettes, alcohol, gambling etc.

Policies to correct negative consumption externalities and prevent overuse of common pool resources

Market based policies: indirect taxes

(Pigovian tax)

-impose an indirect tax on the good whose consumption creates external costs in order to correct a negative externality 🡪 change prices, incentives for consumers to change their consumption patterns etc.

-difficult to determine the value of the external costs (who and what is affected…)

-goods have an inelastic demand (imposing taxes works to increase government tax revenue, while not significant decreasing the quantity demanded

-large tax revenues can be used to finance education programmes to discourage consumption of particular goods

Policies to correct negative consumption externalities and prevent overuse of common pool resources and their evaluation

Government legislation and regulation

legal restrictions on activities to prevent/ limit consumer activities

Examples: smoking in public places or age restrictions forcing sellers to do business only with adults or placing restrictions on cars entering city centers.

Education and awareness creation

can be used to try to persuade consumers to buy fewer goods with negative externalities

Examples: anti-smoking campaigns, campaigns to avoid consumption of unhealthy foods, using public transportation to economise on petrol use, improving home insulation to reduce oil consumption, providing information to consumers on the amount of carbon produced by air travel.

Positive production externality

External benefits created by producers

Example: R&D, new technology

Not only the firm but also society benefits from it

When the free market underallocated resources to the production of the good: too few resources are allocated to its production, and too little of it is produced.

Qm < Qopt and MPC < MSC at the point of production, Qm

There is a welfare loss (involves external benefits for society that are lost because not enough of the good is produced).

Correcting positive production externalities

Direct government provision: The government intervenes by providing good and services itself 🡪 this has the effect of shifting the supply curve (=MPC curve) downward (to the right)

Subsidies: the government provides a subsidy to a firm per unit of the good produced that is equal to the external benefit. The result is to increase quantity produced. The problem of underallocation of resources and underprovision of the good is corrected, and allocative efficiency is achieved.

Positive consumption externality

External benefits created by consumers

Example: education, health care, vaccination

Benefit the person who receives the education, but gives rise to external benefit, involving social benefit

When the free market underallocated resources to the production of the good and too little of it is produced relative to the social optimum.

Qm < Qopt and MPB < MSB at the point of Qm

There is a welfare loss (loss of social benefit due to underproduction of the good).

Merit goods: goods that are held to be desirable for consumers, but which are underprovided by the market

Correcting positive consumption externalities

Legislation or advertising: promote greater consumption (eg. education compulsory up to a certain age)

Direct government provision: The government intervenes by providing good and services itself 🡪 this has the effect of shifting the supply curve (=MPC curve) downward (to the right)

PUBLIC GOODS

Public goods are: goods that would not be provided at all in a free market. Reasons:

They are non-excludable

They are non-rivalrous – that makes it pointless for private individuals to provide

Lack of public goods - considered to be a market failure, as goods are of benefit to society.

Examples: national defence, flood barriers (pure public good), street lighting, lighthouses (quasi public goods) as could be supplied by the free market to some extent.

Free-rider problem: no one will pay for a flood barrier, in the hope that someone else will do it. The good will not be provided by the free market. If one person is protected by a flood barrier, it does not stop other people from being protected at the same time. The private benefit from a flood barrier would be very small relative to the cost, the social benefit to all would be huge and probably greater than the cost.

Government intervention:

they may provide the public good themselves, use of taxpayers' money to fund

They may subsidise private firms, covering all costs, to provide the good.

Note