What can be done about these Externalities?

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What can be done about these Externalities?

Whether the externality is negative, in which case too much of the good in question is produced and consumed, or positive, so too little is produced and consumed, the problem is the same. When both consumers and producers strive to maximise their own utility in the free market, the result is an inefficient allocation of society's resources.

If there is no incentive for either consumers or producers to solve the problems associated with externalities then it is the job of the government to intervene. Here are some of the options open to the government.

The classic textbook solution to the problem of negative externalities (especially with pollution) is to use taxation.

Remember that imposing a tax on a good causes its supply curve to shift to the left, ceteris paribus, because it causes the costs of the producer to rise. Although the producer may pass on some, or all, of the tax on to the consumer through higher prices (depending on the elasticity of the demand curve), it is the producer who actually pays the tax bill.

The size of the negative externality, or external cost, is the difference between the marginal social cost curve and the marginal private cost curve. If the government can correctly assess the true external cost then it can set the tax at exactly that level, so that the marginal private cost curve shifts until it superimposes itself on to the marginal social cost curve. This would mean that the equilibrium price and quantity reached by consumers and producers would now be the same as the socially optimal equilibrium.

The diagram below is a reproduction of the first diagram in the 'externalities' section. As the government imposes taxes, the MPC curve will slowly shift. This makes the welfare loss triangle shrink, and it is totally eliminated once the MPC line shifts to the same position as the MSC line.

Taxing the polluters

Some textbooks use the term internalising the externalities to explain what is going on here. By imposing a tax, the government is forcing consumers and producers to allow for the externality when they make their decisions. The 'internalising' part of the phrase means 'bringing the externality into the market mechanism', rather than keeping it external where it difficult to cope with it.

The major problem with this solution is that it is very difficult for the government to work out exactly what the size of the externality is. If they under-estimate its size, the MPC curve will shift to the left but not quite reach the MSC curve. Production will still be too high and the price too low. If they over-estimate its size, the MPC will shift pass the MSC curve on the left, pushing prices up higher than they should be and causing output to fall below the optimal level.

Other problems include higher prices for consumers (especially for goods like petrol, where demand is very inelastic), which reduces their consumer surplus. But some would say that, in the case of petrol for example, cars are big polluters so the ever increasing price of petrol is only now beginning to reflect the external cost of using cars. It is still cheaper to travel from, say, London to Manchester by car as long as three or four people share one car, compared with buying separate return rail tickets.

Taxes shift firms' supply curve to the left, forcing them, via the market mechanism, to reduce output and increase the price to reflect the external cost. But what if the good in question has external benefits?

If you remember from above, education is an example of a good that has huge external benefits for society, so if it were left to the free market, output (which in this case means the number of people educated) would be lower than the socially optimal level.

In an effort to increase the output of these type of goods, the government can pay subsidies to the producers. This will cause the supply curve to shift to the right resulting in a higher output and lower prices. In fact, education in this country is free for all children up to the age of 16. The subsidy is so big that the price is zero at the point of use.

Although in an ideal world the solution of 'internalising the externalities', which uses the market mechanism, would be perfect, in the real world, as we have discussed, it is difficult to get the tax level right. In some situations the government feels that their intervention needs to be a little more direct.

Instead of taxing pollution, why not just ban it? Or at least legislate to control pollution levels. For example, cars now have to do an emissions test when they go in for their MOT.

This all seems very straight forward, but similar problems arise. How severe should the legislation be? If a piece of legislation causes £50 million worth of benefit in terms of reduced pollution, but it cost £60 million to administer (the cost of fixing anti-pollution filters, for example), then the regulation has been a bit over the top. As you can see, again it is difficult for the government to get the balance right.