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Explain and illustrate why the price mechanism is unlikely to lead to an optimum allocation of resources when the production or consumption of a good, results in environmental pollution.

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Introduction

In a market economy changes in price affect the allocation of resources A) Explain and illustrate why the price mechanism is unlikely to lead to an optimum allocation of resources when the production or consumption of a good, results in environmental pollution. B) Evaluate the various policies, which a government might adapt to deal with environmental pollution. A) The optimum allocation of resources is achieved when all resources are efficiently used in a way, which maximises the utility of consumers. It can be represented on the production possibility frontier as all the points along the frontier, with no unemployment within the economy. The price mechanism is determined by the levels of supply and demand of a good/service in an economy. The interactions of supply and demand fix the price. Consumers wish to maximise their satisfaction whereas producers wish to maximise their profits. Profit and revenue are the signals to firms to alter the levels of production. If the production or consumption of a good results in an environmental problem, this problem is known as a negative externality. ...read more.

Middle

B) There are four main policies used by governments to correct externalities such as environmental pollution. These are taxes, regulation, the extension of property rights and pollution permits. With the example of the chemical industry polluting the atmosphere and rivers with its waste products, it was found that the price is too low and quantity produced too high due to the externalities of pollution, to give allocative efficiency. The use of environmental taxes helps to encourage firms to reduce their pollution levels. Governments aim to tax polluters equally to the value of the social costs of pollution, however it is quite difficult to calculate the correct amount, which a firm needs to pay due to the difficulty in assessing the actual cost to society of the pollution emitted. The government try's to set the rate of tax so that it is equal to the value of externality. As costs of production to the firm then increase, firms reduce their output to X from Y, and so reduce their pollution emissions. Environmental taxes allow the market to determine what is produced and how resources are allocated. ...read more.

Conclusion

However if property rights are extended so it is possible to claim for the damage caused by the company, then it increases their costs so in fact they pay for the true social cost of their pollution. Extending property rights like this is a way of internalising the externality. An advantage to extending property rights is that the governments doesn't have to assess the cost of the pollution, however the problem is that it is very difficult to extend property rights, who should decide who pays? And if the court decides then how do they decide on the correct level of compensation? Finally the introduction of pollution permits is a policy sometimes adopted by the government. This is when there is a certain limit set on the amount of pollution allowed. The government then allocates permits to individual firms and polluters, which can be traded between firms who want them. The main advantage of permits over regulation is that costs are lower to industry and so society, than with regulation. Each firm would also try to reduce their pollution emissions if they knew that they are able to sell on the spare permits and make profit that way. ...read more.

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