Government Intervention for Externalities

We will be taking a closer look at these now (because it's required by the syllabus)

1. Indirect (Pigouvian) Taxes

• Indirect Taxes are those that are put on goods and services rather than individuals or firms. They make goods more expensive. They are also sometimes called Pigouvian taxes, named after an economist called, you guessed it, Pigou. 

• They can be used to correct both types of negative externalities (although it is better suited for production):

Because an indirect tax decreases the equilibrium output (both consumption and production), it can also be used for negative externalities of consumption, as the end goal there is also to decrease Q. 

However, as you know from the previous chapter, the effectiveness of an indirect tax depends on the elasticity of the good, and most demerit goods are inelastic, meaning indirect taxes are not super effective.

2. Carbon Taxes

• A carbon tax is similar to an indirect tax, but specifically targets sources of carbon emissions, such as polluting factories. This tax is imposed on the polluting firms, who then hopefully emit less carbon.

• Carbon taxes are used to combat negative externalities of production, and has a diagram identical to indirect taxes:

3. Legislation & Regulation

• Instead of putting a form of tax on negative externalities, the government could instead introduce laws or policies that aim to reduce the welfare loss. This works for both types of negative externalities:

• It is illegal for those under 18 to consume alcohol in many countries. This is a regulation created by governments to reduce the negative externalities of consuming alcohol, such as causing a disturbance. (Negative Externality of Consumption)

• Many countries also have laws set against overfishing, where fishing boats are only allowed to catch specific amount of fish a year. This is legislation by the government to reduce the negative externalities of overfishing, such as extinction of fish species. (Negative Externality of Production) 

4. Education & Awareness Creation

• Instead of forcing a tax or strict laws, the government can instead encourage more merit goods and less demerit goods by educating its population. This means education/awareness creation can be used for all 4 externalities, both positive and negative.

5. Tradable Permits

• Tradable permits are "permission slips" that firms can get in order to be allowed to pollute. These permits are then able to be bought and sold amongst companies. This can be an effective way to limit negative externalities of production. Here is an example:

• Company A has 1000 permits, allowing them to pollute 1000kg of CO2. They have factories that can in theory pollute less, but don't bother. Company B also has 1000 permits, but desperately needs another 500. Company A can sell 500 of its own permits to B, and they both benefit. A is incentivized to specialize in clean technology, as they make extra money from selling these permits.

• By limiting the amount of permits issued in the first place, the government can ensure pollution targets are met. 

6. International Agreements

• As many externalities are worldwide, governments sometimes team up and make common taxes, rules, or campaigns. 

• An example is the Paris Agreement, where almost every country worldwide collectively aim to reduce their carbon emissions (reduce their negative externalities of production). This is much more effective than if just a few countries had done so.

7. Collective Self-Governance

• Collective Self-Governance refers to voluntary actions done by local communities in order to reduce their negative externalities of consumption. 

• For example, beach plastic clean-ups are a form of collective self-governance, where a community reduces the negative externalities of consumption that plastic generates.

8. Subsidies

• Subsidies are forms monetary government assistance for firms or an industry. They reduce the price of goods. 

• Subsidies can be used for both types of positive externalities:

Because a subsidy increases the equilibrium output (both consumption and production), it can also be used for positive externalities of consumption, as the end goal there is also to increase Q. 

9. Direct Government Provision

• Finally, direct government provision is when the government ensures there is enough of an underprovided merit good. 

• For example, the government builds most schools and parks, because the private market would not provide enough themselves. 

• Government provision can be used for positive externalities of production: