the government can respond to externalities in one of two ways
1. Command-and-control policies regulate behavior directly.
2. Market-based policies provide incentives so that private
decision makers will choose to solve the problem on their own.
Environmental Protection Agency (EPA) is
the government agency with the task of developing and enforcing regulations aimed at protecting the environment.
Environmental regulations can take many forms. such as
EPA dictates a maximum level of pollution...or...requires
firms to adopt a particular technology to reduce emissions.
Market-Based Policy 1: Corrective Taxes and Subsidies
Taxes enacted to deal with the effects of negative externalities are called corrective taxes or Pigovian taxes
the government can internalize the externality by
taxing activities that have negative externalities and subsidizing activities that have positive externalities.
Economists usually prefer corrective taxes to regulations as a way to deal with pollution because
they can reduce pollution at a lower cost to society.
An ideal corrective tax would equal
the external cost from an activity with negative externalities,
an ideal corrective subsidy would equal
the external benefit from an activity with positive externalities.
Example of how EPA reduces the amount of polutions
1) Regulation: The EPA could tell each factory to reduce its pollution to300 tons of glop per year.
2) Corrective tax: The EPA could levy a tax on each factory of $50,000 for each ton of glop it emits.
Why Corrective Tax is more efficient than regulations?
Corrective Tax would be more efficient as it give strong incentive for the firm to find alternative than paying the pollution tax.
the corrective tax places a price on the right to pollute. Just as markets allocate goods to those buyers who value them mos
Example of Corrective Tax
The regulation requires each factory to reduce pollution by the same amount. An equal reduction, however, is not necessarily the least expensive way to clean up the water. It is possible that the paper mill can reduce pollution at lower cost than the stee
Benefit of Corrective Tax
Unlike other form of Tax creating dead weight lost. Corrective taxes alter incentives to account for the presence of externalities and thereby move the allocation of resources closer to the social optimum.
Why Is Gasoline Taxed So Heavily?
Government wants to reduce Negative Externialities
Traffic congestion, Accidents, Pollution.
Market-Based Policy 2: Tradable Pollution Permits
allowing the deal is good policy.The deal must make the owners of the two factories better off because they are
voluntarily agreeing to it as long as the total amount of pollution remains the same. Thus, social welfare is
enhanced by allowing the paper mi
The invisible hand will ensure that this new market allocates the right to pollute efficiently." means
the permits will end up in the hands of those firms that value them most highly, as judged by their willingness to pay A firm's willingness to pay for the right to pollute, in turn, will depend on its cost of reducing pollution: The more costly it is for
Reducing pollution using pollution permits or using corrective tax has common effect that is ......
With corrective taxes, polluting firms must pay a tax
to the government. With pollution permits, polluting firms must pay to buy the permit.
Both corrective taxes and pollution permits internalize the
externality of pollution by making it costly for firms
Corrective Tax price setting is determined by
Find the acceptable quantity of pollution then find the price on demand curve. the supply curve for pollution rights is perfectly elastic (because firms can pollute as much as they want by paying the tax),
Corrective Tax graph
Tradable permits will limit the amount of pollutions by
selling limited number of permits by auction and let the market force determine the price of the permit.
Pollution Permits graph
Coase theorem - 1
the proposition that if private parties can bargain without additional cost over the allocation of resources, they can solve the problem of externalities on their own
Coase theorem - 2
The Coase theorem says that private economic actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights,
the interested parties can reach a bargain in which everyone is better off and the outcom
Reason for exception to Coase Theorem
transaction costs, the costs that parties incur in the process of agreeing to and following through on a bargain. ..or.. when the number of interested parties is large and cost of coordination is high.