Correcting market failure resulting from externalities

Question 1

NPE: use of government regulations

Answer 1

-law to control how or how much a firm can produce
Example:
-limit quantity of output produced
-limit emission of a pollutant by setting maximum level permitted
-require firms to install technology to reduce emissions

Question 2

Imposing a pigouvian tax

Answer 2

1) Tax on output
-Tax imposed on producer shifts the MPC curve inward due to higher costs of production
-Firm is now paying for external cost
-Lower quantity of good produced, new equ at MSC=MPB=MSB
-optimal size of tax shifts MPC to the MSC

2) Tax per unit (carbon tax)
-calculated based of exact amount of pollutant produced
-MPC shifts inward however there are alternate energy sources, creates an incentive for firms to switch to other less polluting energy sources

Question 3

Tradable pollution permits

Answer 3

-Government gives each firm a specific number of permits to produce a particular level of pollutants
-Can be bought and sold among other firms (gain or lose profit)
-However large companies can buy up more permits
- Supply is fixed (inelastic)
-Demand determined by firms level of emissions
-Use price mechanism to allocate resources

Question 4

PCE: subsidies
direct provision
regulation
advertising

Answer 4

-Subsidies are a grant to the producer which decreases production costs
-It shifts the MPC curve outward
-Price falls

-Direct provision
-Governments are actively involved in direct provision of education and health which both have large positive consumption externalities

-Regulation
-consumption required by law (education/ minimum school leaving age is 16)

-Advertising
-people encouraged to consume so others can also receive the benefits

Question 5

Evaluating policies to correct NPE: market based policies

Answer 5

MARKET POLICIES
-ADVANTAGES
-Taxes and permits help to internalise the externality
-the polluter needs to pay for the effects

-Creates incentives for firms to cut back on pollution if possible
-Clean firms can continue producing while dirty firms need to pay to be able to do so

-Provide a source of government revenue which can be used to correct the market failure
for example they could subsidise green technology

-DISADVANTAGES
-Difficult to design a tax in equal value to the external cost of the pollution

-Large firms can absorb additional costs and continue producing at same level

-Firms may pass on liability of the tax especially if for and inelastic good- regressive

Question 6

Evaluating policies to correct NPE: government regulations

Answer 6

ADVANTAGES:
-Simple to introduce compared to market based

-Force polluting firms to comply and reduce pollution levels (taxes offer firms the choice)

-More commonly used

DISADVANTAGES:
-Do not allow the externality to be internalised - there is not market based incentive

-Unable to make distinction between firms that have higher or lower costs of polluting

-Unable to provide incentive to use less polluting resources- size of externality remains the same

-Costs of policing and problems with enforcement

Question 7

Evaluating policies to correct PCE:

Answer 7

ADVANTAGES
-Both subsidies and direct provision are effective in lowering the price of the good to increase consumption

DISADVANTAGES
-Effectiveness of a subsidy depends on price elasticity of demand
-Subsidy lowers production costs so these savings should be passed onto consumers however if the demand is inelastic it will not significantly increase production and the market failure will not be corrected

-External benefits of increasing consumption may be difficult to quantify especially if the benefits take a long time to take effect

-Distributional concerns- does it target the problem effectively

-Lobbyists might influence gov to subsidise certain goods which is an example of rent seeking behaviour