IB Economics 2.8.2 Government Intervention in Response to Externalities and Common Pool Resources Notes

Match the Correction to the Gap

1. Intervention aims to move the market from $Q_M$ back to the social optimum $Q^*$.
2. The right tool depends on the type of externality.
3. A negative externality over-provides ($Q_M > Q^*$), so the fix pushes output down to $Q^*$.
4. A positive externality under-provides ($Q_M < Q^*$), so the fix pulls output up to $Q^*$.
5. A common pool resource is over-used, so the fix caps use to what it can regenerate.

Correcting Negative Externalities: Taxes

1. The same tax fixes a polluting factory and a demerit good: it raises the private cost so output falls to $Q^*$.
2. A Pigouvian (indirect) tax raises private costs, and when it is set equal to the external cost it cuts output to the social optimum $Q^*$, where $MSB = MSC$.

1. A carbon tax is charged per tonne of CO2, so firms cut their carbon intensity to avoid it, and MPC rises by less than the external cost.
2. Output then falls only from $Q_{M1}$ to $Q_{M2}$, still above $Q^*$, so the tax reduces the externality rather than removing it.

1. A tax is flexible, raises revenue, and rewards cleaner methods over time; its weakness is measuring the external cost accurately.

Correcting Negative Externalities: Regulation and Tradable Permits

1. Command-and-control regulation forces the cut directly through emission standards, licences, or output limits.
2. But regulation must be monitored and enforced, which has an opportunity cost.
3. Tradable permits cap total pollution and let firms trade the right to emit.
4. The permit supply is fixed, so as demand for permits rises the price climbs from $P_1$ to $P_2$, adding to MPC and cutting output to $Q^*$.
5. Permits fix the quantity a tax leaves uncertain and find the cheapest cuts on their own.
6. But the cap must be right: the early EU Emissions Trading System issued too many permits, so the price collapsed.
7. Tradable permits also cap common pool resource use, such as fishing quotas, covered below.

Correcting Positive Externalities and Merit Goods

1. A positive externality under-provides the good, from production (research, training) or consumption (vaccination), so the fix raises output toward $Q^*$.
2. Supply-side tools cut the producer's cost: a subsidy or direct provision shifts MPC down to MSC.
3. That raises output to $Q^*$ and lowers a merit good's price so consumption rises.
4. Demand-side tools raise how much consumers value the good.
5. Education, advertising, campaigns, legislation, and nudges shift MPB up to MSB until consumption reaches $Q^*$.
6. Match the tool to the spillover: a positive production externality is fixed supply-side, while a positive consumption externality can be fixed from either side.

Managing Common Pool Resources

1. Common pool resources are over-used because no one owns them, so they are protected by capping and coordinating use.
2. Collective self-governance lets users manage the resource together, since they share the loss if it is depleted.
3. Regulation, tradable permits, and international agreements add external limits where users cannot coordinate.
4. Self-governance needs good communication, and boundary-less resources like the open ocean are very hard to govern this way.

Which Tool Fixes Which Externality

1. Negative externalities: a Pigouvian tax, regulation, or tradable permits push output down to $Q^*$.
2. The same tax fixes both a polluting factory and a demerit good.
3. Positive externalities: a subsidy or direct provision (supply side), or education and legislation (demand side), pull output up to $Q^*$.
4. Common pool and cross-border externalities: collective self-governance, permits, and international agreements cap and coordinate use.