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Market Failure. Evaluation of policies to correct externalities. Negative production externalities: Market-based policies and regulations. Market-based policies: Advantages

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Market failure

Market Failure

Evaluation of policies to correct externalities

C. Bordoy

UWC Maastricht

Negative production externalities market based policies and regulations
Negative production externalities: Market-based policies and regulations

  • Market-based policies: Advantages

    • Internalise the externality, ie, costs that were external are made internal: they are now paid for by producers & consumers.

    • Taxes on emissions are superior than taxes on output:

      • Taxes on output only provide incentive to reduce output produced.

C. Bordoy

UWC Maastricht

  • Taxes on pollutants provide incentives to firms to reduce use of polluting resources and use production methods that pollute less.

  • Costs of reducing emissions differ:

    • Firms with the lower costs will be the ones most likely to cut their emissions to avoid the tax.

    • Firms with the higher costs will be the ones least likely to cut their pollutants and so will pay the tax

      Taxation thus leads to lower pollution levels at a lower overall cost.

  • In the case of tradable permits:

    • Firms with a low cost of reducing emissions will do so and sell excess permits.

    • Firms facing a high cost will be forced to buy additional permits.

C. Bordoy

UWC Maastricht

  • Market-based policies: disadvantages use of polluting resources and use production methods that pollute less.

  • Taxes:

    • Difficulty in designing a tax equal in value to the amount of the pollution. The following questions need to be answered:

      • Identify which production methods produce pollutants.

      • Identify the harmful pollutants: technically difficult, plus much controversy among scientists over extent of harm by each pollutant.

      • Attach a monetary value to the harm.

    • Risk that, even while paying the tax, some polluting firms may not lower their pollution levels

C. Bordoy

UWC Maastricht

  • Tradable permits. In addition to technical problems, listed above:

    • Require the gov to set a maximum (cap) level for each type of pollutant, which requires technical information that may not be available. If cap is too high it will not reduce pollutants enough. If it is too low, permits will be very costly.

    • Method to distribute permits must be fair.

      In practice, it is unlikely that these policies can achieve optimal results.

C. Bordoy

UWC Maastricht

  • Government regulations: advantages above:

    • Simple and easy to implement. Sometimes only option if practical difficulties of market-based methods are too great.

    • Regulations force polluting firms to comply and reduce pollution levels (which taxes may not always do)

  • For these reasons they are more commonly used in countries around the world.

C. Bordoy

UWC Maastricht

  • Government regulations: disadvantages above:

    • They do not create market-based incentives.

    • Unable to provide incentives for firms to use less polluting resources and thus reduce the size of the externality.

    • Pollution is reduced at a higher overall cost.

    • Lack of sufficient technical information→ only partial effect in reducing the pollution created.

    • Policing involves costs and there may be problems with enforcement.

C. Bordoy

UWC Maastricht

Negative consumption externalities market based policies government regulation and advertising
Negative consumption externalities: market-based policies, government regulation and advertising

  • Indirect taxes (market-based measure) are preferred, as they internalise the externality.

  • Advantages:

    • They create incentives for consumers to change their consumption patterns by changing relative prices.

C. Bordoy

UWC Maastricht

  • Disadvantages: government regulation and advertising

    • Technical difficulties involved in measuring the value of the external costs, as basis to design the tax.

    • Some of the goods whose consumption leads to negative externalitites have an inelastic demand, so decreases in quantity demanded may not be significant. In order to achieve Qopt a very high tax may be needed, but would be politically unacceptable.

C. Bordoy

UWC Maastricht

Advertising & persuasion government regulation and advertising

  • Advantage: simplicity

  • Disadvantages:

    • Cost to the gov of advertising campaigns, funded by tax revenues, which have opportunity costs.

    • These methods may not be effective enough in reducing the spillover cost.

C. Bordoy

UWC Maastricht

Regulations government regulation and advertising

  • Very effective in reducing the external costs of smoking but cannot be used to reduce externalities caused by consumption of other goods, such as gasoline.

C. Bordoy

UWC Maastricht

Final remarks
Final remarks government regulation and advertising

  • Governments must be selective in the methods they use to reduce consumption externalities, depending on the particular good that creates the external costs.

  • With all policies it is only possible to move the economy in a direction towards correction of the externality, rather than achieving Qopt.

C. Bordoy

UWC Maastricht

Evaluation of policies to correct positive production and consumption externalities
Evaluation of policies to correct positive production and consumption externalities

Direct provision and subsidies

  • Advantages:

    • Very effective in increasing the quantity of the good produced and consumed.

    • Lower price for consumers.

C. Bordoy

UWC Maastricht

  • Disadvantages: consumption externalities

    • They both involve the use of government funds that rely on tax revenues and have an opportunity cost. Choices must be made on:

      • Which goods should be supported, and

      • By how much

        Ideally, economic criteria would specify the amount of social benefits expected in relation to the cost of providing them. However, it is very difficult in practice to calculate the external benefit and therefore to calculate which goods should be supported and with which level.

C. Bordoy

UWC Maastricht

  • In the real world it is very inlikely that governments are able to shift the MPC or MPB curves by the amount necessary to correct the positive externalities.

  • C. Bordoy

    UWC Maastricht

    Legislation and advertising sometimes make choices based on political rather than economic criteria.

    • Limitations:

      • Only sometimes can they be effective by helping shift the MPB curve in the right direction.

        • Very positive effects in certain cases (compulsory schooling up to a certain age) but ineffective in others (they cannot on their own increase consumption of health services and education to the optimum level).

      • They have the further effect of raising the price to consumers, which may make the good unaffordable for some consumer groups.

    • They can sometimes be used more effectively if they are implemented together with direct provision and subsidies. For example, education, where legislation goes together with direct provision by the government.

    C. Bordoy

    UWC Maastricht