Market Failure
Evaluation of policies to correct externalities
C. Bordoy
UWC Maastricht
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
Taxes:
1.
Difficulty in designing a tax equal in value to
the amount of the pollution. The following
questions need to be answered:
1.
2.
3.
2.
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:
1.
2.
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
1.
2.

Simple and easy to implement. Sometimes
only option if practical difficulties of marketbased 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
1.
2.
3.
4.
5.
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


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:
1.
2.
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

Advantage: simplicity

Disadvantages:
1.
2.
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

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


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
Direct provision and subsidies

Advantages:
1.
2.
Very effective in increasing the quantity of
the good produced and consumed.
Lower price for consumers.
C. Bordoy
UWC Maastricht

Disadvantages:
1.
They both involve the use of government
funds that rely on tax revenues and have an
opportunity cost. Choices must be made on:
a.
b.
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
2.

Governments are often susceptible to
political pressures and sometimes make
choices based on political rather than
economic criteria.
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

Limitations:
1.
Only sometimes can they be effective by helping
shift the MPB curve in the right direction.

2.

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