Government actions in externalities

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. 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 firm’s supply to be the marginal social cost. In other words,
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 firm’s 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 firm’s 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.


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. Subsidies: a government payment that is made to producers. By adding subsidies, the firm’s supply curve becomes

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.

Using Subsidies for Positive Externalities

Recall that the firm’s 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 firm’s supply curve is now

S₁ = MPC - Subsidy
Thus, the new market equilibrium is at the intersection of S₁ and MPD curve.