2.8.2 Government intervention in response to externalities and common pool resources Notes

Pigouvian Taxes

1. Pigouvian Tax is a method used by governments to correct negative externalities as:
   1. It makes the production of the good for a firm more expensive (increases costs of production).
   2. Hence, this causes a decrease in production of the good (moves the curve towards allocative efficiency.

In the diagram above, the following is observed:

1. An upward shift of the MPC curve towards the MSC curve.
2. This will decrease the production or quantity from $Q_m$ until it reaches the socially optimum level $Q_{opt}$.

Carbon Taxes

1. With carbon emissions being one of the most pressing environmental issues nowadays, carbon taxes are induced to combat the issue.
2. This tax makes it more expensive to use fossil fuels which emit carbon, as the quantity of emissions are taxed, leading to higher costs of production.
3. Therefore, firms decrease their use of fossil fuels by switching to alternatives, which helps preserves the environment.

Observing the diagram above:

1. The introduction of a carbon tax helps shift the MPC curve to the MSC curve.
2. However, as there are alternatives to carbon emitting fossil fuels, which do not get affected from carbon tax, a lot of firms may switch to those alternatives.
3. Hence, firms still pollute the environment, but by a lower factor, which is represented by the shift from $MSC_1$ to $MSC_2$
4. Therefore the externality may not be fully corrected, but rather reduced.

Tradable Permits

1. In search of tackling pollution, governments can use tradable permits:
   1. The government will decide its acceptable amount of pollution per period, and divide it into a number of permits
   2. As a result each firm will be given its own limit, above which, if the firm pollutes, they will be penalised.
   3. However, firms can buy or sell these permits to other the firms who are interested, at a price determined by market forces.
   4. Normally, firms sell permits when they pollute below their cap limit.
   5. Further, firms buy permits when they pollute above their cap limit.
2. Therefore, tradable permits are known as a market-based policy to reduce negative externalities.

Figure 3 above represents the market for tradable permits. As can be seen:

1. The quantity of permits is fixed at $Q_{tp}$, and the supply is perfectly inelastic because the amount of tradable permits available is fixed by the government.
2. Initially for a firm to have a pollution permit, they need to pay price $P_1$.
3. However as the economy's production, pollution will likely increase too. Resultantly, the demand for extra tradable permits will increase, shifting the demand curve to the right ($D_1 \rightarrow D_2$).
4. This increase in demand, with a fixed supply, increases considerable the price for extra pollution permits ($P_1 \rightarrow P_2$).