Externalities and Public Policy

Government policies to deal with externalities and examples of externalities

There are a few different types of policies that the government can implement to correct externalities. In the case of pollution, which is a classic externality problem, governments traditionally impose environmental standards to regulate what pollutants and how much of those pollutants can be emitted. More recently, governments have started to implement more market-friendly solutions such as emission tax and tradeable emission permits to address this externality problem.

Examples of tackling externalities: Environmental Standards

Over the last 60 years, the U. S. government has attempted to answer these questions:

1. How much are we polluting?

2. Who is bearing the external cost?

3. Who is responsible for extending that cost outside the economic mechanism?

4. Can public policy discourage economic actors (producers and consumers) from excessive pollution activities?

5. What are the tradeoffs?

To that end, Congress has passed and amended environmental policy to reflect the changing energy needs, environmental concerns, technology limitations, and the nature of positive and negative externalities. A measured response to these questions has helped shape a moderate environmental policy and delivered results in some markets.

However, critiques have highlighted that the small gains over the last 60 years reflect policy inadequacy. The arguments are that it is increasingly hard to implement these policies in local markets that compete with foreign markets that adhere to a different set of rules. As a result, alternative models are emerging.

At the moment, pollution is still considered a negative externality. So, policymakers are tackling pollution through taxation and tradable permits.

Examples of tackling externalities: Emissions Tax

Emissions taxes are a market-based solution that addresses the externality problem of pollution.

When the government imposes an emission tax, this cost affects the emitters' bottom line. So it becomes an incentive that drives internal management to appropriate a budget for emission reduction to a socially optimal quantity. Polluters are said to have internalized the externality when they acknowledge pollution as an external cost to society and take necessary steps to absorb that social cost in their unit input cost. Economics studies have indicated that a punitive emissions tax is more effective (cost-minimizing) than environmental standards. A tax designed to correct for the effects of external costs is known as Pigouvian taxes, named after the economist A.C. Pigou who spearheaded this idea.

Fig 1. - Emissions tax

Figure 1 shows the effect of an emissions tax. After the government imposes the tax, the supply curve shifts up by the tax amount. The equilibrium quantity with tax (Q₁) is less than the equilibrium quantity without tax (Q₀). P_c is the price that consumers now pay for the good. This price is higher than the price they pay without tax - P₀. On the other hand, P_p is the price that the producer receives for the good after-tax, which is lower than the price they would receive without tax, P₀.

Critiques of the emissions tax argue that government officials are not always sure about the right levy amount because it may not positively affect the environment if it is too low. But on the other hand, an unnecessarily high fee may have a disruptive effect on the market. So, policymakers have developed an alternative strategy - issuing tradable emissions permits.

Examples of tackling externalities: Tradable emissions permits

Another market-based solution to address the externality problem of pollution is tradable emissions permits.

The tradable aspect of the permit allows a transaction exchange where firms that find it easier to reduce pollution can sell some of their permits to other firms struggling with emission reduction. This mechanism creates a market where economic actors buy and sell rights to pollute. Therefore, firms with government-issued permits can cut their emissions way below their permits threshold and have some excess permits to sell at a market rate to firms needing pollution permits. As with emission taxes, tradable permits incentivize polluters to internalize the externality.

Polluters will always pick tradable permits or emission taxes over environmental standards because the cost-saving benefits encourage them to do the right thing: invest in emission reduction technology that lowers emission levels to socially optimal quantities. However, the shortcoming of these tradable permits is difficulty in determining the optimal pollution quantity. For instance, there is always a risk of issuing permits to polluters who lie about their data, abuse the process and sell the permits to several other emitters.

Public policy dealing with positive and negative externalities

Public policy dealing with positive and negative externalities would depend on the type of externality. Economists categorize externalities into positive and negative externalities. The meaning is straightforward: positive externalities are external benefits, and negative externalities are external costs.

Positive externalities: private versus social benefits

A common policy tool for the government to deal with positive externalities is subsidies.

The marginal benefit to the condom user is a marginal private benefit (MPB). The marginal benefit to society as a whole is the marginal social benefit (MSB). The difference between the MPB and MSB is the marginal external benefit (MEB). Therefore,$MSB=MPB+MEB$. The key lesson here is that public policy is necessary to take the marginal social benefit into account. A free-market economy has no incentive to engage in production or consumption that increases external benefits.

Fig 2. - Optimal Pigouvian subsidy

Figure 2 above shows a positive externality that is being regulated by a subsidy. As there are external benefits associated to this particular good, the government provides a subsidy to increase the consumption of this good thereby eliminating deadweight loss (represented by the red triangular area). Due to the subsidy, the MPB curve shifts to where the MSB curve is, thereby increasing quantity demanded from Q₀ to Q_subsidy. The optimal Pigouvian subsidy is equal to the size of the marginal external benefit and allows to lower the price that consumers pay (from P₀ to P_c), whilst raising the price that producers receive (from P₀ to P_p). The subsidy expense is represented by the blue rectangular area and is the cost of public policy to deal with a positive externality.

Negative externalities: private versus social cost

Common policy tools to deal with negative externalities include regulations and taxes.

An activity like cement production produces a large amount of pollution. The firm would only consider the marginal private cost (MPC) - the marginal cost of producing an extra unit involving all the production inputs. But the marginal cost to society as a whole is marginal social cost (MSC), which includes the marginal external cost (MEC) in addition to the marginal private cost: $MSC=MPC+MEC$.

In this scenario, the government may choose to impose regulations that limit how much pollution the firm can emit. Alternatively, the government can impose an emission tax that is equal to the marginal external cost or implement a tradeable permit system with the target unit price that is equal to the marginal external cost of pollution.

Fig 3. - Optimal Pigouvian tax

Figure 3 above shows a negative externality that is being regulated by a tax. As there are external costs associated to this particular good, the government imposes a tax to decrease the consumption of this good thereby eliminating deadweight loss (represented by the red triangular area). Due to the tax, the MPC curve shifts to where the MSC curve is, thereby decreasing quantity demanded from Q₀ to Q_tax. The optimal Pigouvian tax is equal to the size of the marginal external cost and allows to increase the price that consumers pay (from P₀ to P_c), whilst lowering the price that producers receive (from P₀ to P_p). The tax revenue is represented by the green rectangular area.