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Understanding Government Actions in Externalities
Dive into the world of externalities and government interventions. Learn how policymakers use various strategies to address market failures, promote economic efficiency, and enhance social welfare through targeted actions.

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Now Playing:Government actions in externalities – Example 0a
Intros
  1. Government Actions in Externalities Overview
  2. Government Actions in Externalities Overview
    How Government Regulates Negative Externalities
    • Property Rights
    • Taxes
    • Emissions Charges
    • Cap-and-Trade
  3. Government Actions in Externalities Overview
    Using Pollution Tax for Negative Externalities
    • Add Tax to MC curve
    • S = MC + tax
    • Supply curve = Marginal social curve
    • Optimal social output achieved
    • Government gains Tax revenue
Examples
  1. Questions Relating to Negative Externalities
    Suppose a firm produces pesticides, but it also produces wastes which they dump into a lake. The following table shows the demand schedule and marginal cost for pesticides. Assume that the marginal external cost is equal to the marginal cost.

    Price

    Quantity

    Marginal Cost

    4

    50

    10

    8

    40

    8

    12

    30

    6

    16

    20

    4

    20

    10

    2

    1. If there are no regulations for the waste, what is the quantity and price of pesticides produced? What is the marginal external cost?

    2. If residents now have property rights for the lake, how would the firm change its quantity and price of pesticides?

Government actions in externalities
Jump to:NotesConceptExampleFAQsPrerequisites
Notes
How Government Regulates Negative Externalities

The government can take action against negative externalities in three ways
  1. Property Rights: By establishing these rights, we can confront producers with the costs of their actions. This gives them incentive to change the quantity supplied.

    Economically, firms realize their actions and external cost so their private MC curve becomes the MSC curve.

    2. How Government Regulates Negative Externalities Property Rights
  2. Taxes: If the government sets a tax equal to the external cost, then the firm will have to pay both the private marginal cost and tax. This leads to the firms supply to be the marginal social cost. In other words,
    3. MPC + tax = MSC

  3. Emission Charges: The government sets a price per unit of pollution. The more pollution the firm makes, the more emissions charges the firm must pay. This is an alternative to taxes.

  4. Cap-And-Trade: The government assigns a permit which tells you the cap (pollution quota) of the firm. Each permit may be different for each firm.

    Note: firms trade permits until the marginal pollution cost is equal to the price of the permit.

Using Pollution Tax for Negative Externalities

Recall that the firms supply curve is the MPC curve.

S0 = MPC

We also have the demand curve MSD. When a pollution tax is implemented, we add the tax to the MPC curve. Thus, the firms supply curve is now

S1 = MPC + tax

Since the tax is equal to the external cost, then we also notice that

MSC = S1

Thus, the new market equilibrium is at the intersection of S1 and MSD curve.

Using Pollution Tax for Negative Externalities

How Government Regulates Positive Externalities

The government can take action against positive externalities in four ways:
  1. Public Production:: When the government implements public production, consumers realize the external benefits, thus changing their private MPB curve to the MSB curve. This achieves efficient market equilibrium

    2. How Government Regulates Positive Externalities Public Production

  2. Subsidies: a government payment that is made to producers. By adding subsidies, the firms supply curve becomes

    3. S = MPC - Subsidy

    Since the product is cheaper to produce, firms produce more to compensate for the underproduction from external benefits.

  3. Vouchers: a token that is provided from the government and given to households. Consumer realizes the extra benefit gained from the token, and so the marginal private demand becomes the marginal social demand.

    4. How Government Regulates Positive Externalities Vouchers

Using Subsidies for Positive Externalities

Recall that the firms supply curve S0 is the MPC curve, and the demand curve is MPD.

Suppose MSC = MPC. When subsidy is implemented, we subtract the subsidy from the MPC. Thus, the firms supply curve is now

S1 = MPC - Subsidy

Thus, the new market equilibrium is at the intersection of S1 and MPD curve.

Using Subsidies for Positive Externalities
Concept

Introduction: Government Actions in Externalities

Government actions play a crucial role in addressing externalities, which are the unintended effects of economic activities on third parties. The introduction video provides a comprehensive overview of this topic, serving as an essential foundation for understanding the complexities of externalities and their impact on society. By watching this video, viewers will gain insights into how governments intervene to mitigate negative externalities and promote positive ones. Negative externalities, such as pollution, require government intervention through regulations or taxes to reduce their harmful effects. Conversely, positive externalities, like education or public health initiatives, often need government support to maximize their benefits to society. The video emphasizes the importance of balancing these actions to achieve optimal outcomes. By exploring various government strategies, including subsidies, taxes, and regulations, viewers will develop a deeper understanding of how policymakers address externalities to promote economic efficiency and social welfare.

Example

Government Actions in Externalities Overview How Government Regulates Negative Externalities

  • Property Rights
  • Taxes
  • Emissions Charges
  • Cap-and-Trade

Step 1: Property Rights

The first method the government can use to regulate negative externalities is by establishing property rights. By doing so, the government confronts producers with the costs of their actions. For instance, if a producer is causing pollution, the property rights will make them acknowledge and pay for these external costs. This incentivizes producers to change the quantity supplied to account for these costs. Economically, this is represented by a shift in the supply curve to the left, reflecting the marginal social cost curve. This adjustment leads to a new market equilibrium where the external costs are acknowledged, resulting in a more efficient market outcome.

Step 2: Taxes

Another method is the imposition of taxes. If the government sets a tax equal to the external cost, the firm will have to pay both the tax and the private marginal cost. This effectively makes the firm's cost curve align with the marginal social cost curve. Graphically, this is shown by adding the tax to the marginal private cost, resulting in a new equilibrium where the firm produces less, thus internalizing the external cost. This method ensures that the firm reduces its production to a level that reflects the true social cost of its activities.

Step 3: Emissions Charges

Emissions charges are another tool the government can use. Instead of a blanket tax, the government sets a price per unit of pollution. For example, if the price per unit of pollution is $10 and a firm produces 50 units, the firm would have to pay $500 in emissions charges. This method directly ties the cost to the amount of pollution produced, incentivizing firms to reduce their emissions. The more pollution a firm produces, the higher the charges, which encourages firms to minimize their pollution to reduce costs.

Step 4: Cap-and-Trade

The cap-and-trade system involves the government assigning permits that set a cap on the amount of pollution a firm can produce. Each firm receives a different permit based on their needs, and these permits can be traded among firms. For instance, if Firm A has a permit for 40 units but only needs 30, it can trade with Firm B, which needs more. This system ensures that the total pollution remains within a set limit while allowing firms flexibility in how they meet their production needs. Firms will trade permits until the marginal pollution cost equals the price of the permit, ensuring an efficient allocation of pollution rights.

FAQs

  1. What are externalities and why are they important in economics?

    Externalities are the unintended effects of economic activities on third parties not directly involved in the transaction. They are important because they can lead to market inefficiencies. Positive externalities, like education, create benefits for society beyond the individual, while negative externalities, such as pollution, impose costs on society. Understanding and addressing externalities is crucial for achieving optimal resource allocation and maximizing social welfare.

  2. How do governments address negative externalities?

    Governments address negative externalities through various methods, including:

    • Taxes (e.g., carbon taxes) to increase the cost of harmful activities
    • Regulations to limit or control activities causing externalities
    • Cap-and-trade systems to create a market for emission rights
    • Establishing and enforcing property rights to allow for private negotiations
    These approaches aim to internalize the external costs and align private incentives with social costs.

  3. What methods do governments use to promote positive externalities?

    To promote positive externalities, governments typically use:

    • Subsidies to reduce the cost of beneficial activities
    • Direct public provision of goods or services (e.g., public education)
    • Vouchers to support consumption while maintaining consumer choice
    • Tax incentives for activities that generate positive externalities
    These methods aim to increase the production or consumption of goods and services that benefit society as a whole.

  4. How do pollution taxes work to address negative externalities?

    Pollution taxes work by increasing the cost of polluting activities to match their true social cost. This is done by imposing a tax equal to the external cost per unit of pollution. Graphically, this shifts the supply curve upward, aligning it with the marginal social cost curve. As a result, the market reaches a new equilibrium where the price reflects both private and social costs, leading to reduced production of the polluting good and incentivizing cleaner production methods.

  5. What are the challenges in implementing government actions on externalities?

    Implementing government actions on externalities faces several challenges:

    • Accurately measuring the value of externalities
    • Determining the optimal level of intervention (tax, subsidy, or regulation)
    • Balancing economic efficiency with political and social considerations
    • Avoiding unintended consequences, such as industry relocation or over-reliance on government support
    • Ensuring compliance and effective enforcement of policies
    Policymakers must carefully consider these factors to design effective and appropriate interventions.

Prerequisites

Understanding government actions in externalities is a crucial aspect of economics and public policy. While there are no specific prerequisite topics provided for this subject, it's important to recognize that a strong foundation in basic economic principles and market dynamics is essential for grasping the complexities of government interventions in cases of externalities.

To fully comprehend government actions in externalities, students should have a solid understanding of fundamental economic concepts. These include supply and demand, market equilibrium, and the basic principles of microeconomics. Familiarity with these topics allows students to better analyze how externalities disrupt market efficiency and why government intervention may be necessary.

Additionally, knowledge of market failures is crucial when studying government actions in externalities. Externalities are a type of market failure, and understanding how markets can fail to allocate resources efficiently provides context for government interventions. This background helps students appreciate why governments might choose to take action in certain situations.

A grasp of public policy and governance is also beneficial when exploring this topic. Understanding how governments function, make decisions, and implement policies provides insight into the mechanisms used to address externalities. This knowledge helps students evaluate the effectiveness and potential consequences of various government actions.

Furthermore, familiarity with environmental economics can be particularly useful, as many examples of externalities and government interventions relate to environmental issues. Concepts such as pollution, resource depletion, and sustainability often come into play when discussing externalities and government responses.

While not strictly prerequisites, having a background in game theory and behavioral economics can enhance students' understanding of how different actors respond to externalities and government interventions. These fields provide insights into strategic decision-making and human behavior, which are relevant when analyzing the effects of government actions on individuals and firms.

Lastly, a basic understanding of policy instruments such as taxes, subsidies, and regulations is helpful. These are common tools used by governments to address externalities, and familiarity with their mechanics and potential impacts aids in evaluating their appropriateness and effectiveness in different scenarios.

By building a strong foundation in these related areas, students will be better equipped to analyze and critically evaluate government actions in externalities. This comprehensive understanding allows for more nuanced discussions and insights into the complex interplay between market forces, externalities, and government interventions in modern economies.