Market Failure

1. Market Failure Evaluation of policies to correct externalities C. Bordoy UWC Maastricht

2. Negative production externalities: Market-based policies and regulations • Market-based policies: Advantages • Internalise the externality, ie, costs that were external are made internal: they are now paid for by producers & consumers. • Taxes on emissions are superior than taxes on output: • Taxes on output only provide incentive to reduce output produced. C. Bordoy UWC Maastricht

3. Taxes on pollutants provide incentives to firms to reduce use of polluting resources and use production methods that pollute less. • Costs of reducing emissions differ: • Firms with the lower costs will be the ones most likely to cut their emissions to avoid the tax. • Firms with the higher costs will be the ones least likely to cut their pollutants and so will pay the tax Taxation thus leads to lower pollution levels at a lower overall cost. • In the case of tradable permits: • Firms with a low cost of reducing emissions will do so and sell excess permits. • Firms facing a high cost will be forced to buy additional permits. C. Bordoy UWC Maastricht

4. Market-based policies: disadvantages • Taxes: • Difficulty in designing a tax equal in value to the amount of the pollution. The following questions need to be answered: • Identify which production methods produce pollutants. • Identify the harmful pollutants: technically difficult, plus much controversy among scientists over extent of harm by each pollutant. • Attach a monetary value to the harm. • Risk that, even while paying the tax, some polluting firms may not lower their pollution levels C. Bordoy UWC Maastricht

5. Tradable permits. In addition to technical problems, listed above: • Require the gov to set a maximum (cap) level for each type of pollutant, which requires technical information that may not be available. If cap is too high it will not reduce pollutants enough. If it is too low, permits will be very costly. • Method to distribute permits must be fair. In practice, it is unlikely that these policies can achieve optimal results. C. Bordoy UWC Maastricht

6. Government regulations: advantages • Simple and easy to implement. Sometimes only option if practical difficulties of market-based methods are too great. • Regulations force polluting firms to comply and reduce pollution levels (which taxes may not always do) • For these reasons they are more commonly used in countries around the world. C. Bordoy UWC Maastricht

7. Government regulations: disadvantages • They do not create market-based incentives. • Unable to provide incentives for firms to use less polluting resources and thus reduce the size of the externality. • Pollution is reduced at a higher overall cost. • Lack of sufficient technical information→ only partial effect in reducing the pollution created. • Policing involves costs and there may be problems with enforcement. C. Bordoy UWC Maastricht

8. Negative consumption externalities: market-based policies, government regulation and advertising • Indirect taxes (market-based measure) are preferred, as they internalise the externality. • Advantages: • They create incentives for consumers to change their consumption patterns by changing relative prices. C. Bordoy UWC Maastricht

9. Disadvantages: • Technical difficulties involved in measuring the value of the external costs, as basis to design the tax. • Some of the goods whose consumption leads to negative externalitites have an inelastic demand, so decreases in quantity demanded may not be significant. In order to achieve Qopt a very high tax may be needed, but would be politically unacceptable. C. Bordoy UWC Maastricht

10. Advertising & persuasion • Advantage: simplicity • Disadvantages: • Cost to the gov of advertising campaigns, funded by tax revenues, which have opportunity costs. • These methods may not be effective enough in reducing the spillover cost. C. Bordoy UWC Maastricht

11. Regulations • Very effective in reducing the external costs of smoking but cannot be used to reduce externalities caused by consumption of other goods, such as gasoline. C. Bordoy UWC Maastricht

12. Final remarks • Governments must be selective in the methods they use to reduce consumption externalities, depending on the particular good that creates the external costs. • With all policies it is only possible to move the economy in a direction towards correction of the externality, rather than achieving Qopt. C. Bordoy UWC Maastricht

13. Evaluation of policies to correct positive production and consumption externalities Direct provision and subsidies • Advantages: • Very effective in increasing the quantity of the good produced and consumed. • Lower price for consumers. C. Bordoy UWC Maastricht

14. Disadvantages: • They both involve the use of government funds that rely on tax revenues and have an opportunity cost. Choices must be made on: • Which goods should be supported, and • By how much Ideally, economic criteria would specify the amount of social benefits expected in relation to the cost of providing them. However, it is very difficult in practice to calculate the external benefit and therefore to calculate which goods should be supported and with which level. C. Bordoy UWC Maastricht

15. Governments are often susceptible to political pressures and sometimes make choices based on political rather than economic criteria. • In the real world it is very inlikely that governments are able to shift the MPC or MPB curves by the amount necessary to correct the positive externalities. C. Bordoy UWC Maastricht

16. Legislation and advertising • Limitations: • Only sometimes can they be effective by helping shift the MPB curve in the right direction. • Very positive effects in certain cases (compulsory schooling up to a certain age) but ineffective in others (they cannot on their own increase consumption of health services and education to the optimum level). • They have the further effect of raising the price to consumers, which may make the good unaffordable for some consumer groups. • They can sometimes be used more effectively if they are implemented together with direct provision and subsidies. For example, education, where legislation goes together with direct provision by the government. C. Bordoy UWC Maastricht