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 ($P_1 \rightarrow P_2$).
5. Therefore, those firms that produce more will have to pay a much higher price for extra pollution permits from other firms.
6. This encourages encourages to reduce their pollution to:
   1. Save costs by not having to buy extra tradable permits.
   2. Increase revenue by selling their spare tradable permits to other firms.

Government Legislation and Regulation

1. Government legislation typically involves the following approaches:
   1. Emission stadards
   2. Emission license
   3. State protected, emission free zones
   4. Limitations of production size

1. As a result, observing the diagram, the government will decrease the production of the goods which are created using pollution emitting activities and shift the MPC curve upwards, closer to the MSC curve at the social optimal level of production.
2. These type of approaches can be effective in dealing with negative externalities, as the law can ban certain undesirable activities.
   1. Legislation can be very effective and once in effect, it can work very fast to deal with the negative externalities.

Collective Self-Governance

This approach suggests that if the users of a resource are fully in control of the resource, they will work collaboratively to manage it, as they know if they fail to manage, their future use of the resource will be endangered.

Education and Awareness Creation

1. Education and awareness creation about the activities that generate negative externalities help nudge firms to change their consumption/production patterns.
2. This can help reduce the negative externalities.
3. Therefore, the MPC curve will be shifted upwards towards the MSC curve.

International Agreements

1. While the negative externalities can be emitted by one country, the effect of it can be felt globally.
2. For example the depletion of ozone layer, which is damaged by the release of greenhouse gases, protects Earth from ultraviolet radiation.
3. Therefore, international agreements need to be made to monitor and correct these externalities to reduce the negative effects on the international environment (for everyone).

Subsidies

1. By providing subsidies the government can help firms which produce negative production externalities such as carbon emissions or toxic chemical emissions, to shift towards more sustainable approaches such as solar energy which may be expensive.
2. By doing this, the government will decrease the quantity of pollutants and shift the MPC curve towards the MSC curve, and the socially optimal level $Q_{opt}$.

Government Provision

1. Governments may decide to provide certain goods/services themselves in order to address the market failures caused by the market firms in their competitive setting.
2. By doing this, the governments will ensure the accessibility of goods and correct the inefficiencies and externalities created by private firms.