Below is a diagram, which illustrates how negative externalities arise:
From the diagram one can see that market failure is caused due to the overproduction of goods and services, which aren’t accounted for. S1 is the supply curve when only private costs are taken into consideration. S2 is when social costs are taken into the consideration. As firms minimise costs they are able to produce more at a lower price as shown at point A (when only private costs have been taken into consideration). Point B is where the firm should produce if it were to take the Social costs into consideration. This is otherwise known as the ‘socially optimum level’ of production. Thus the overproduction, which is not, accounted for cause a failure in the market mechanism.
In order to correct the market failure, the government would have to use some method of intervention, which would reduce the overproduction and thus reduce the negative externality. Methods, which are most frequently used, are either some form of regulation or a form of financial intervention. The main purpose of these methods is to either reduce the MSC (Marginal Social Cost) or increase the MPC (Marginal Private Cost). The general effect of these methods is to raise the costs for the producer, thus causing the price to rise and reducing the production (supply)
Below is a diagram, which illustrates the effect of Government Intervention with regards to a negative externality. This particular diagram is related to a tax or fine, which may be imposed.
From the diagram above one can see that S1 is also the MPC (Marginal Private Cost), D is the MPB (Marginal Private Benefit) and that S2 is the MSC (Marginal Social cost), which includes the MPC as well as the imposed tax. The effect of the government intervention (i.e. the tax) is to shift the price up to P2 and the production to Q2, thus showing an increase in price as well as a reduction is the quantity produced from Q1 to Q2, and therefore reducing the negative externality.
Part B:
As mentioned in part a) of the question, there are various methods which can be implemented in order to reduce the negative externality and thus bring forward a solution to the market failure. Also as mentioned in part a), the main reason for the market failure to occur is the overproduction of the goods/services or in other words the considerable gap between the MSC and the MPB.
Businesses in the UK are known to produce 40% of the total Carbon Dioxide that is emitted in the UK each year. The UK government has a self-imposed target of reducing carbon dioxide emissions to 20%, below the levels in the 1990’s, by they year 2010.
In order to meet this self-imposing target the government will have to implement policies, which reduce the carbon dioxide emissions. Although a government usually has many choices as to how to reduce the negative externality, only three of these policies will be evaluated in this essay. Regulation, Permits and the use of indirect taxes and fines will all be evaluated.
Firstly, regulation is when a government enforces various laws or legislation in order to stop or reduce the external costs, otherwise known as the negative externality. Regulation is usually backed up by various inspections, checks and often fines which a party has to bear if the laws are not adhered to.
Regulation is seen as an easy method to implement and for the producer to understand. Also it is a relatively cheap method. Although this is the case regulation is often seen as a ‘crude policy’ as it can often result in businesses paying a lot of fines and loosing money.
In the case of carbon dioxide, the government could regulate the emission of each and every firm that produces carbon dioxide in the UK. They could set a cut-off level, which would legally stop firms from emitting more than the cut-off level. Although this sounds relatively simple to establish, it is in fact a tedious task. First of all, in order to regulate the emission of carbon dioxide a suitable method of measuring the amount would have to be established. This would cost the government, both in terms of time and money for the research in developing a suitable device. Also another problem would be the fact that it would requires regular inspections and check to be carried out, for which people have to be recruited. Even that would not stop some firms exceeding the cut-off level as not everyone can be caught doing wrong. Regulation is therefore more a way of reducing the scale of the externality rather than to stop it from happening. Although this is the case, Regulation also has its advantages in terms of costs and the fact that it is usually easy to implement. Below is a diagram that illustrates the effect of regulation.
Through regulation the supply decreases from S1 to S2, thus also reducing the quantity produced and therefore reducing the external costs.
The other method that could be used is the enforcement of permits. Permits are a variation of regulation, in other words a permit is regulating negative externalities through a direct contract. For example if the government wanted to control emissions of carbon dioxide into the atmosphere, it could issue permits to pollute, the total of which equals the maximum amount of carbon dioxide it wishes to see emitted over time. The permits would then be allocated to individual firms or polluters. The permits are then trade-able for money between polluters. The advantage of this being that firms, which succeed in reducing their emission can then sell their permits to other firms/polluters. Another advantage of this is that the costs to society are paid for rather then just reducing them as with regulation. The use of permits also gives an extra incentive for firms to improve their method of production so that less pollutants are emitted. The main disadvantage of permits is the fact that they still don’t stop the pollution. Also it is difficult to place a monetary value on a negative externality. Although it has disadvantages it is still more effective then regulation as some of the external costs are still paid for. Permits can be especially effective if used as a method of ‘Ring Fencing’. This means that the revenue the government generates from polluters is spent on the areas, which are polluted.
Indirect taxes can also be used as a method of reducing the negative externality. The effect of an indirect tax is to reduce supply because the taxes increase the producer’s costs and so they make less money at their original prices. This is shown in the table below.
The table above shows that less is supplied at each price due to the increase in the cost of producing. The £5 tax added to costs, has reduced the supply at each price. For example at £20, 90units are normally produced but after the tax only 80 units are produced.
In the case of carbon dioxide, a direct tax method would me more suitable as it would target emissions directly. Although this is the case, a method of measuring the emission is still required. Carbon Dioxide emissions have the attractive property that the amount of carbon dioxide produced is proportional to the amount of carbon in the fuel being burnt. This means that it is possible to simply tax the amount of carbon being burnt, and thus it is easy to tax a particular fuel based on its carbon content. Another issue that has to be taken into consideration is the rate of tax. Some big firms may not take much notice of the tax if it is negligible.
The diagram on the next page shows the effect of taxes are shown on the diagram below:
From the diagram one can see that the supply has decreased to S2 due the increasing costs, this intake causes a reduction in the quantity supplied and also increases the price.
The advantages of using taxes as a form of government intervention is the fact that it usually has quick results this is because a tax pushes up the cost for a producer and thus reduces the supply. A further advantage is that a tax also creates greater incentives for the producer to reduce its negative externality. The disadvantage of using taxes is that they are aggressive; this means that they take a great percentage of poor peoples income. It is also difficult to place a monetary value on the negative externality and therefore deciding the rate of tax is difficult. An issue, which policy makers worry about when designing a new tax is its distributional implications. The UK government has recently introduced a Climate change levy, the government wanted to make sure that the price of energy to domestic consumers would not increase.
Whichever policy is used the cost of the goods involved will go up either to comply with regulation, or because of indirect taxes. As previously mentioned regulation is not as effective at stopping the negative externality as indirect taxes, as it just reduces the scale of the externality. Also regulation does not pay for the external costs to society. Permits are effective, but when it comes to environmental pollution it is complicated to implement permits as it is difficult to place a monetary value, followed by designating each area with a permit. Many other factors can influence the design of an effective policy to be used.
Economist generally prefer using taxes rather than regulation, the main reason for this being that a tax is much more effective in reducing the externality as well as paying for external costs. Taxes are said to be more effective on the economic front as they give faster results.
Gordon Brown, the chancellor of the UK has introduced a new energy tax in the year 99, which would be imposed on industry from the year 2110. This would be the largest and most radical package of environmental tax to be announced in the UK. Its main aim is to push up costs for producers, thus decrease supply and reduce the quantity demanded. The overall effect being the reduction in carbon emissions.
The energy tax was said to achieve two objectives. The first being the reduction in carbon emissions and the second being a reduction in unemployment. The main reason for unemployment falling is due to the decreasing costs for employment of labour, thus causing an increase in demand of labour.
There have been many oppositions against this new tax. An argument is that the tax rate is too small and so there will be no major impact on large businesses. Another argument put forward is that a quarter of the emissions come from home users and so they too should be taxed in order to reduce emissions. Some economist also believe that carbon should be taxed rather then the energy. Finally the main argument against the energy tax is the fact that a tax has to be introduced in every country in order to reduce emissions. By only putting taxes on UK businesses, there wouldn’t be much reduction in the world’s carbon emissions and instead the competitiveness of UK firms would be worse off.
To conclude with, there are no right or wrong policies; each policy has its advantages and disadvantages. In the case of environmental pollution, a direct tax method is said to be better off theoretically. Although this is the case it is still to early to say whether Gordon Brown’s Energy Tax has worked.
