Government Intervention Policies for Negative Externalities
Government Intervention Policies for Negative Externalities
Government Regulation
Governments implement policies to correct negative externalities of production and consumption.
Key policy prescriptions discussed:
Regulation.
Indirect taxes to reduce output.
Tradable permits (carbon trading schemes).
Assigning property rights.
Importance
Relevant for Paper 1 (Part B - evaluation/discussion-based answers) and Paper 2 (Part D - data response).
Helps evaluate pros and cons of government intervention in markets to correct failures.
Government Ban
Definition: A government will usually ban a good or service when the marginal social benefits at every level of output are negative, meaning there are no social benefits to consuming or producing it.
Pros:
Reduced consumption (especially of demerit goods).
Example: Prohibition in the US (1920-1933) led to a 60% reduction in alcohol consumption and reduced liver cirrhosis.
Reduced polluting production methods.
Cons:
Rise of black markets: Demand will be met illegally if supply is banned.
This often leads to increased illegal activity and organized crime.
Example: Drug trafficking in Mexico.
Increased government expenditure on policing and enforcement, leading to opportunity costs.
Regulating Negative Externalities
Often applied to production externalities.
Encourages research and development to reduce input costs due to increased red tape.
Forces firms to become more efficient and sustainable.
Forms of Regulation:
Setting limits on pollutants emitted into the atmosphere or water sources.
Fines for exceeding limits.
Severe breaches can lead to closure of firms.
Disadvantages:
Increased costs for businesses, disincentivizing foreign direct investment (FDI).
Green tape (environmental regulations) can discourage FDI, especially in less developed countries (LDCs).
May lead to multinational corporations (MNCs) to seek countries with less regulation (race to the bottom), shifting negative externalities to LDCs.
Influencing Production and Consumption
Consumption: Restrictions on activities like smoking and drinking in public places.
Makes these activities more inconvenient, thus decreasing demand for demerit goods.
Setting age limits can reduce consumption of demerit goods.
Production: Setting hours of operation for alcohol outlets.
Warning labels on demerit goods.
Licensing requirements for selling cigarettes and alcohol.
Downsides:
Enforcement of laws can be problematic, especially in LDCs.
Seen as limiting individual rights and freedom of choice.
Arguably inefficient; undermines the market mechanism, potentially leading to allocative loss.
Indirect Taxes
Definition: Taxes on consumption or expenditure used to modify behavior.
An indirect tax is considered an expenditure tax.
Aim: To deter firms from producing or consumers from purchasing by increasing the price.
Objective: To internalize externalities by factoring the costs or benefits to third parties into the market price.
Correcting Production Externality: Coal-Fired Power
Market left to its own devices overproduces at 100 units at 5 per gigawatt hour.
Externality: 7 of social costs not factored into the market price.
Imposition of tax: Decreases supply, reducing output to 90 units and increasing price (approximately 6-7).
Ideal tax: Marginal private cost equals marginal social cost, reducing output to 80 units.
Correcting Consumption Externality: Alcopops
Market left to its own devices over consumes at 100 units at 6.
Aim: Reduce demand through advertising and education to reach optimal consumption of 80 units.
Reality: Education and advertising have limited impact on teenagers.
Solution: Implement a tax (e.g., 2008 Labor government tax of 69% on alcopops).
Tax achieves socially optimal consumption, but not necessarily the socially optimal price.
Effects of Tax
Consumers bear part of the tax through increased price.
Example: A 4 tax may result in a 2 price increase for consumers due to elasticity of demand.
Teenagers are income sensitive, leading to unitary elasticity of demand.
Revenue collected can be used for social purposes (advertising campaigns, rehabilitation, education).
Activity 1 Analysis
Externality per bottle of alcopops: 4 when output is 100.
Private cost: 6 per unit, output 100 units.
Optimal consumption: 80 units at a social optimal price of 4
Tax applied: 4 closing the externality gap
Tax burden: Producer and consumer each bear 2
Reasons for Government Tax
Reduce teenage consumption due to negative externalities.
Source of government revenue.
Reduce binge drinking culture among teenagers.
Tax is likely to achieve objectives because of income effect on younger people.
Potential substitution to spirits by existing drinkers.
Tradable Permits
Specifically for negative externalities of production.
Definition: Government sets acceptable pollution level, issues credits to firms, and limits emissions.
Firms face fines for exceeding limits.
Firms can buy or sell permits, creating a market.
Incentivizes highly polluting firms to clean up operations.
Example: Five Firms in Coal Fired Power Market
Market produces 100 gigawatts of electricity with 100 million tonnes of greenhouse gases emitted.
Firm 1: 20 gigawatts = 30,000,000 tonnes. (most polluting firm)
Firm 2: 20 gigawatts = 25,000,000 tonnes
Firm 3: 20 gigawatts = 20,000,000 tonnes
Firm 4: 20 gigawatts = 15,000,000 tonnes
Firm 5: 20 gigawatts = 10,000,000 tonnes. (most efficient producer)
Government wants to halve CO2 emissions.
Tradable permit scheme mandates emissions not to exceed 50,000,000 tonnes.
Each firm receives 10,000,000 tonnes worth of tradable permits.
Impact on Firms
Firm 1 (Dirtiest): Emits 30,000,000 tonnes but is only allowed 10,000,000 faces significant fines.
Input costs increase, and variable costs exceed revenue, forcing shutdown.
Firm 1 can sell their 10,000,000 tonnes worth of CO2 tradable permits.
Firm 2 needs 15 permits, Firm 3 needs 10 permits, and Firm 4 needs 5 permits.
Firm 5 (Most Efficient) can buy permits to double output.
Market Dynamics
Firm 1 shutting down reduces market supply, increasing the power price.
Incentive for efficient firm (5) to increase output because of higher power prices.
Firm 5 is in a better negotiating position to acquire permits, as it can afford to pay more to double its output.
Tradable permits become available as Firm 1 exits the market.
If permits are initially priced at $23 per tonne (like the carbon tax), the efficient producer may offer a higher price, increasing the market price of tradable permits (e.g., to $50 per permit).
Environmental Groups
Environmental groups can buy permits and destroy them, further reducing the capacity for coal-fired power production.
This increases the price of remaining permits.
Higher permit prices incentivize firms to reduce CO2 emissions.
Long-Term Effects on Coal-Fired Power Market
Short run: Pollution decreases by 50% due to government limits.
Long run: Output reduction is less proportional as firms invest in technology to reduce emissions (e.g., carbon capture and storage).
Tradable Permits: Pros & Cons
Advantages:
Market-based solution with incentives and rewards for producers.
Environmental groups can reduce pollution by buying and retiring permits.
Efficient producers acquire the most permits.
Less costly to regulate.
Disadvantages:
Can make pollution seem acceptable, giving the wrong impression.
Example: If permit prices are low, dirty producers (e.g., Hazelwood) can continue operating by buying cheap permits without reducing emissions.
Can perpetuate pollution and reliance on fossil fuels.
Not as simple or straightforward as an emissions tax.
Assigning Property Rights
Definition: Explicit rights to use an asset or resource, creating ownership with associated responsibilities.
Incentivizes owners to consider all costs associated with the property.
Internalizes negative externalities.
Extending Property Rights
Consumers (Offended Party): Example: BHP's copper mining in Papua New Guinea polluted local water sources.
Villagers, as owners of the water source, had the right to demand restoration and compensation, they were ultimately successful when suing BHP to fix the river.
Producers (Offending Party): Example: Open-cut miners responsible for rehabilitating the site and ensuring no impact on third parties.
Responsible for the negative externalities caused by their property.
If open cut mines buy/lease the land they are responsible for ensuring that activities do not impact on third parties and are responsible for compensation.
Real Life Examples
2010: Chinese coal carrier (MV Xinyin) ran aground near Rockhampton, spilling oil on the Great Barrier Reef.
Queensland government sued the owner for damages to clean up the spill.
Compensation increased import costs, reducing supply and internalizing the externality.
Advantages of Property Rights
Market-based solution.
Incentivizes firms not to pollute.
Reduces government expenses as there is no need for regulatory/monitoring bodies.
Offender and victim can arrive at equitable compensation.
Problems with Property Rights
Governments cannot always extend property rights (e.g., deforestation in the Amazon, pollution from China to the USA).
Difficulties in extending property rights (e.g., James Hardie asbestos case, time gap between exposure and disease).
Difficulties in assessing the value of property rights (subjective valuation).
Cannot always extend property rights (e.g. Australia impacting by deforestation of the Amazon).
Conclusion
Review of government regulations, indirect taxes, tradable permit systems, and assigning property rights as methods to regulate negative externalities of production and consumption.
These should be the four areas you must talk about when evaluating how effective governments can be in correcting market failure.
Government Intervention Policies for Negative Externalities
Government Regulation
Governments implement policies to correct negative externalities of production and consumption.
Key policy prescriptions discussed:- Regulation.
Indirect taxes to reduce output.
Tradable permits (carbon trading schemes).
Assigning property rights.
Importance
Relevant for Paper 1 (Part B - evaluation/discussion-based answers) and Paper 2 (Part D - data response).
Helps evaluate pros and cons of government intervention in markets to correct failures.
Government Ban
Definition: A government will usually ban a good or service when the marginal social benefits at every level of output are negative, meaning there are no social benefits to consuming or producing it. Bans are typically reserved for goods or services with severe negative externalities that cannot be effectively managed through other means.
Pros:
Reduced consumption (especially of demerit goods).
Bans effectively eliminate or significantly reduce the availability of harmful products.
Example: Prohibition in the US (1920-1933) led to a 60% reduction in alcohol consumption and reduced liver cirrhosis.
This demonstrates the potential health benefits of banning harmful substances, although the overall success of Prohibition was limited due to other factors.
Reduced polluting production methods.
By banning highly polluting activities and technologies, governments can rapidly decrease environmental damage.
Cons:
Rise of black markets: Demand will be met illegally if supply is banned.
This often leads to increased illegal activity and organized crime.
Black markets are often unregulated and can lead to even more dangerous products and practices.
Example: Drug trafficking in Mexico.
The illegal drug trade exemplifies how bans can create lucrative opportunities for criminal organizations.
Increased government expenditure on policing and enforcement, leading to opportunity costs.
Enforcing bans requires significant resources, which could be used for other public services.
Regulating Negative Externalities
Often applied to production externalities.
Encourages research and development to reduce input costs due to increased red tape.
Forces firms to become more efficient and sustainable.
Forms of Regulation:
Setting limits on pollutants emitted into the atmosphere or water sources.
Specifies maximum allowable levels of emissions to reduce environmental impact.
Fines for exceeding limits.
Acts as a deterrent to non-compliance, incentivizing firms to stay within regulatory limits.
Severe breaches can lead to closure of firms.
Provides a strong enforcement mechanism, ensuring firms take regulations seriously.
Disadvantages:
Increased costs for businesses, disincentivizing foreign direct investment (FDI).
Regulations can be costly for firms to implement, potentially reducing their competitiveness.
Green tape (environmental regulations) can discourage FDI, especially in less developed countries (LDCs).
Complex or overly burdensome regulations can deter investment and economic growth.
May lead to multinational corporations (MNCs) to seek countries with less regulation (race to the bottom), shifting negative externalities to LDCs.
MNCs may relocate to countries with weaker environmental standards to avoid compliance costs.
Influencing Production and Consumption
Consumption: Restrictions on activities like smoking and drinking in public places.
Makes these activities more inconvenient, thus decreasing demand for demerit goods.
Setting age limits can reduce consumption of demerit goods.
Restricts access to harmful products for younger individuals, reducing overall consumption.
Production: Setting hours of operation for alcohol outlets.
Limits the availability of alcohol during certain times, potentially reducing excessive consumption.
Warning labels on demerit goods.
Informs consumers about the potential harms of products, influencing their purchasing decisions.
Licensing requirements for selling cigarettes and alcohol.
Controls the sale of harmful products, ensuring sellers meet certain standards and restrictions.
Downsides:
Enforcement of laws can be problematic, especially in LDCs.
Weak legal systems and corruption can hinder the effective enforcement of regulations.
Seen as limiting individual rights and freedom of choice.
Critics argue that such measures infringe upon individual autonomy and decision-making.
Arguably inefficient; undermines the market mechanism, potentially leading to allocative loss.
Overregulation can distort market signals and lead to suboptimal resource allocation.
Indirect Taxes
Definition: Taxes on consumption or expenditure used to modify behavior.
Taxes are imposed on goods and services to discourage consumption or production of harmful products.
An indirect tax is considered an expenditure tax.
Aim: To deter firms from producing or consumers from purchasing by increasing the price.
By raising the cost of harmful goods, taxes aim to reduce demand and consumption.
Objective: To internalize externalities by factoring the costs or benefits to third parties into the market price.
Taxes help to reflect the true social cost of goods and services in their market price.
Correcting Production Externality: Coal-Fired Power
Market left to its own devices overproduces at 100 units at 5 per gigawatt hour.
Without intervention, the market produces more than the socially optimal level of electricity due to external costs.
Externality: 7 of social costs not factored into the market price.
The social cost of pollution from coal-fired power plants is not reflected in the market price.
Imposition of tax: Decreases supply, reducing output to 90 units and increasing price (approximately 6-7).
Taxes make production more expensive, leading to a decrease in supply and an increase in price.
Ideal tax: Marginal private cost equals marginal social cost, reducing output to 80 units.
The optimal tax level is where the private cost to producers equals the total social cost.
Correcting Consumption Externality: Alcopops
Market left to its own devices over consumes at 100 units at 6.
Without intervention, the market consumes more than the socially optimal level of alcopops due to external costs.
Aim: Reduce demand through advertising and education to reach optimal consumption of 80 units.
Public awareness campaigns aim to reduce demand for harmful products.
Reality: Education and advertising have limited impact on teenagers.
Teenagers may not respond effectively to advertising and education efforts.
Solution: Implement a tax (e.g., 2008 Labor government tax of 69% on alcopops).
Taxes are used to discourage consumption by increasing the price of alcopops.
Tax achieves socially optimal consumption, but not necessarily the socially optimal price.
While taxes can reduce consumption, the market price may not reflect the ideal social cost.
Effects of Tax
Consumers bear part of the tax through increased price.
Consumers pay more for goods and services due to the tax.
Example: A 4 tax may result in a 2 price increase for consumers due to elasticity of demand.
The burden of the tax is shared between consumers and producers, depending on the elasticity of demand and supply.
Teenagers are income sensitive, leading to unitary elasticity of demand.
Teenagers are highly responsive to changes in price due to their limited income.
Revenue collected can be used for social purposes (advertising campaigns, rehabilitation, education).
Tax revenue can fund programs aimed at addressing the negative effects of externalities.
Activity 1 Analysis
Externality per bottle of alcopops: 4 when output is 100.
The external cost associated with each bottle of alcopops is 4.
Private cost: 6 per unit, output 100 units.
The cost to producers for each unit of alcopops is 6.
Optimal consumption: 80 units at a social optimal price of 4
The socially optimal level of consumption is 80 units at a price of 4.
Tax applied: 4 closing the externality gap
A 4 tax is imposed to correct for the externality.
Tax burden: Producer and consumer each bear 2
The tax burden is split equally between producers and consumers.
Reasons for Government Tax
Reduce teenage consumption due to negative externalities.
Taxes are intended to decrease consumption by teenagers due to the harmful effects of alcopops.
Source of government revenue.
Tax revenue can be used to fund public services and programs.
Reduce binge drinking culture among teenagers.
Taxes aim to discourage excessive consumption of alcohol.
Tax is likely to achieve objectives because of income effect on younger people.
Teenagers are more likely to reduce consumption in response to price increases.
Potential substitution to spirits by existing drinkers.
Some consumers may switch to other alcoholic beverages in response to the tax.
Tradable Permits
Specifically for negative externalities of production.
Definition: Government sets acceptable pollution level, issues credits to firms, and limits emissions.
Firms are given permits allowing them to emit a certain amount of pollution.
Firms face fines for exceeding limits.
Firms that exceed their emission limits are penalized.
Firms can buy or sell permits, creating a market.
Firms can trade permits with each other, creating a market for pollution.
Incentivizes highly polluting firms to clean up operations.
Firms have an incentive to reduce emissions to avoid fines or to sell excess permits.
Example: Five Firms in Coal Fired Power Market
Market produces 100 gigawatts of electricity with 100 million tonnes of greenhouse gases emitted.
The total emissions from the coal-fired power market are 100 million tonnes.
Firm 1: 20 gigawatts = 30,000,000 tonnes. (most polluting firm)
Firm 2: 20 gigawatts = 25,000,000 tonnes
Firm 3: 20 gigawatts = 20,000,000 tonnes
Firm 4: 20 gigawatts = 15,000,000 tonnes
Firm 5: 20 gigawatts = 10,000,000 tonnes. (most efficient producer)
Government wants to halve CO2 emissions.
The government aims to reduce CO2 emissions by 50%.
Tradable permit scheme mandates emissions not to exceed 50,000,000 tonnes.
The total allowable emissions under the permit scheme are 50 million tonnes.
Each firm receives 10,000,000 tonnes worth of tradable permits.
Each firm is initially allocated 10 million tonnes of emission permits.
Impact on Firms
Firm 1 (Dirtiest): Emits 30,000,000 tonnes but is only allowed 10,000,000 faces significant fines.
Firm 1 exceeds its emission limit by 20 million tonnes and faces penalties.
Input costs increase, and variable costs exceed revenue, forcing shutdown.
The high cost of fines and permits may force the firm to close.
Firm 1 can sell their 10,000,000 tonnes worth of CO2 tradable permits.
Firm 1 can sell its permits to other firms to generate revenue.
Firm 2 needs 15 permits, Firm 3 needs 10 permits, and Firm 4 needs 5 permits.
These firms need to acquire additional permits to cover their emissions.
Firm 5 (Most Efficient) can buy permits to double output.
Firm 5 can increase its production and emissions by buying permits from other firms.
Market Dynamics
Firm 1 shutting down reduces market supply, increasing the power price.
The closure of Firm 1 reduces the supply of electricity, leading to higher prices.
Incentive for efficient firm (5) to increase output because of higher power prices.
Firm 5 has an incentive to increase production to take advantage of the higher prices.
Firm 5 is in a better negotiating position to acquire permits, as it can afford to pay more to double its output.
Firm 5 can afford to pay more for permits due to its higher efficiency and profitability.
Tradable permits become available as Firm 1 exits the market.
The permits held by Firm 1 become available for other firms to purchase.
If permits are initially priced at $23 per tonne (like the carbon tax), the efficient producer may offer a higher price, increasing the market price of tradable permits (e.g., to $50 per permit).
The price of permits may increase as demand for them rises.
Environmental Groups
Environmental groups can buy permits and destroy them, further reducing the capacity for coal-fired power production.
Environmental groups can reduce overall emissions by buying and retiring permits.
This increases the price of remaining permits.
The price of remaining permits increases as the supply decreases.
Higher permit prices incentivize firms to reduce CO2 emissions.
Higher permit prices make it more expensive for firms to pollute, encouraging them to reduce emissions.
Long-Term Effects on Coal-Fired Power Market
Short run: Pollution decreases by 50% due to government limits.
Pollution is immediately reduced as firms comply with permit limits.
Long run: Output reduction is less proportional as firms invest in technology to reduce emissions (e.g., carbon capture and storage).
In the long run, firms may invest in technology to reduce emissions and increase output.
Tradable Permits: Pros & Cons
Advantages:
Market-based solution with incentives and rewards for producers.
Firms are motivated to reduce emissions through market mechanisms.
Environmental groups can reduce pollution by buying and retiring permits.
Environmental groups can directly impact pollution levels by purchasing and retiring permits.
Efficient producers acquire the most permits.
Efficient firms are able to acquire more permits and increase production.
Less costly to regulate.
Tradable permit systems may be less costly to administer than traditional regulations.
Disadvantages:
Can make pollution seem acceptable, giving the wrong impression.
Critics argue that tradable permits legitimize pollution.
Example: If permit prices are low, dirty producers (e.g., Hazelwood) can continue operating by buying cheap permits without reducing emissions.
Low permit prices may allow polluting firms to continue operating without reducing emissions.
Can perpetuate pollution and reliance on fossil fuels.
Tradable permits may not effectively reduce overall reliance on fossil fuels.
Not as simple or straightforward as an emissions tax.
Tradable permit systems can be complex and difficult to understand.
Assigning Property Rights
Definition: Explicit rights to use an asset or resource, creating ownership with associated responsibilities.
Assigning property rights clearly defines who has the right to use and manage resources.
Incentivizes owners to consider all costs associated with the property.
Owners are more likely to consider the environmental impact of their actions when they have clear property rights.
Internalizes negative externalities.
Negative externalities are factored into decision-making when property rights are assigned.
Extending Property Rights
Consumers (Offended Party): Example: BHP's copper mining in Papua New Guinea polluted local water sources.
Local communities may have the right to clean water sources.
Villagers, as owners of the water source, had the right to demand restoration and compensation, they were ultimately successful when suing BHP to fix the river.
Villagers have the legal right to demand compensation for damages caused by pollution.
Producers (Offending Party): Example: Open-cut miners responsible for rehabilitating the site and ensuring no impact on third parties.
Mining companies are responsible for restoring the environment after mining operations.
Responsible for the negative externalities caused by their property.
Producers are accountable for the environmental impact of their activities.
If open cut mines buy/lease the land they are responsible for ensuring that activities do not impact on third parties and are responsible for compensation.
Real Life Examples
2010: Chinese coal carrier (MV Xinyin) ran aground near Rockhampton, spilling oil on the Great Barrier Reef.
A coal carrier caused an oil spill, damaging the Great Barrier Reef.
Queensland government sued the owner for damages to clean up the spill.
The government sued the owner of the ship for the environmental damage.
Compensation increased import costs, reducing supply and internalizing the externality.
The cost of compensation was factored into the price of imports, reflecting the environmental cost.
Advantages of Property Rights
Market-based solution.
Property rights allow for market-based solutions to environmental problems.
Incentivizes firms not to pollute.
Firms are less likely to pollute when they are held responsible for the environmental impact.
Reduces government expenses as there is no need for regulatory/monitoring bodies.
Property rights can reduce the need for government regulation and monitoring.
Offender and victim can arrive at equitable compensation.
Property rights facilitate negotiations between offenders and victims to determine fair compensation.
Problems with Property Rights
Governments cannot always extend property rights (e.g., deforestation in the Amazon, pollution from China to the USA).
It may be difficult to assign property rights in certain situations, such as deforestation in the Amazon.
Difficulties in extending property rights (e.g., James Hardie asbestos case, time gap between exposure and disease).
There may be challenges in assigning property rights when there is a time gap between exposure and harm.
Difficulties in assessing the value of property rights (subjective valuation).
The value of property rights can be subjective and difficult to assess.
Cannot always extend property rights (e.g. Australia impacting by deforestation of the Amazon).
Conclusion
Review of government regulations, indirect taxes, tradable permit systems, and assigning property rights as methods to regulate negative externalities of production and consumption.
These should be the four areas you must talk about when evaluating how effective governments can be in correcting market failure.