Externalities and Public Policy

Imagine that there is a factory that is emitting pollutants into the air. The heavily polluted air makes the nearby residents sick. What do we do? Do we wait for the free market to come up with a solution by itself? No, don't hold your breath for that. This is a classic externality problem that requires public policy to step in to correct it. Want to learn more about what kinds of policy tools the government has to deal with externalities and which ones might work better? Read this explanation to find out.

Externalities and Public Policy Externalities and Public Policy

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Table of contents

    Meaning of Externalities and Public Policy

    What do we mean by externalities and public policy? We know that when we leave externalities unchecked, they will lead to market failures. This is a situation that requires the government to step in. Public policy dealing with externalities refers to laws, regulations, ordinances, and programs that aim to correct the externalities and achieve socially desirable outcomes.

    Externalities arise when one economic actor's production or consumption actions make another economic actor bear indirect costs or receive indirect benefits of that action

    Dive in deeper in our article on Externalities

    The U.S. legislature has been actively shaping public policy around environmental protection guidelines. The Environmental Protection Agency spearheads this government effort through federal and state programs.

    California is at the forefront of implementing progressive climate laws and a tax regime that offers solar companies subsidies and requires that all houses built after 2030 have solar rooftops. The motivation here is to restructure California's energy mix by shifting incentives from coal-burning power plants to decentralized power generation at the household level.

    Government policies to deal with externalities and examples of externalities

    There are a few different types of policies that the government can implement to correct externalities. In the case of pollution, which is a classic externality problem, governments traditionally impose environmental standards to regulate what pollutants and how much of those pollutants can be emitted. More recently, governments have started to implement more market-friendly solutions such as emission tax and tradeable emission permits to address this externality problem.

    Examples of tackling externalities: Environmental Standards

    Over the last 60 years, the U. S. government has attempted to answer these questions:

    1. How much are we polluting?

    2. Who is bearing the external cost?

    3. Who is responsible for extending that cost outside the economic mechanism?

    4. Can public policy discourage economic actors (producers and consumers) from excessive pollution activities?

    5. What are the tradeoffs?

    Environmental standards are rules that regulate what firms and consumers have to do with regard to pollution. Examples include regulations on car exhaust, wastewater treatment, and emission standards for factories.

    To that end, Congress has passed and amended environmental policy to reflect the changing energy needs, environmental concerns, technology limitations, and the nature of positive and negative externalities. A measured response to these questions has helped shape a moderate environmental policy and delivered results in some markets.

    However, critiques have highlighted that the small gains over the last 60 years reflect policy inadequacy. The arguments are that it is increasingly hard to implement these policies in local markets that compete with foreign markets that adhere to a different set of rules. As a result, alternative models are emerging.

    Activists suggest that environmental policy should move away from standards and instead focus on economics, cost and benefit, and incentive structures that drive innovation and technology breakthroughs. Such policies will attract the best and brightest with business models like carbon sequestration (capturing and storing atmospheric carbon dioxide), deploying tools that absorb pollutants in the atmosphere and convert it into other products.

    At the moment, pollution is still considered a negative externality. So, policymakers are tackling pollution through taxation and tradable permits.

    Examples of tackling externalities: Emissions Tax

    Emissions taxes are a market-based solution that addresses the externality problem of pollution.

    An emissions tax puts a price on pollution that depends on the amount of pollution that a firm emits.

    When the government imposes an emission tax, this cost affects the emitters' bottom line. So it becomes an incentive that drives internal management to appropriate a budget for emission reduction to a socially optimal quantity. Polluters are said to have internalized the externality when they acknowledge pollution as an external cost to society and take necessary steps to absorb that social cost in their unit input cost. Economics studies have indicated that a punitive emissions tax is more effective (cost-minimizing) than environmental standards. A tax designed to correct for the effects of external costs is known as Pigouvian taxes, named after the economist A.C. Pigou who spearheaded this idea.

    externalities and public policy Emissions tax studysmarterFig 1. - Emissions tax

    Figure 1 shows the effect of an emissions tax. After the government imposes the tax, the supply curve shifts up by the tax amount. The equilibrium quantity with tax (Q1) is less than the equilibrium quantity without tax (Q0). Pc is the price that consumers now pay for the good. This price is higher than the price they pay without tax - P0. On the other hand, Pp is the price that the producer receives for the good after-tax, which is lower than the price they would receive without tax, P0.

    Consider two manufacturers: company A emits 100,000 metric tons a year, and company B emits 10,000 tons a year.

    If an environmental standard required them to install technological gadgets that cut their pollution by 20%, then company A would have to reduce emissions to 80,000 metric tons and company B would reduce emissions to 8,000 metric tons.

    But if the government charges an emissions tax per ton of pollutant, the firms would face the same marginal cost of pollution. This will lead to a more efficient outcome where both firms will reduce the pollution to the point where the marginal benefit of emitting pollution equals this tax amount.

    Critiques of the emissions tax argue that government officials are not always sure about the right levy amount because it may not positively affect the environment if it is too low. But on the other hand, an unnecessarily high fee may have a disruptive effect on the market. So, policymakers have developed an alternative strategy - issuing tradable emissions permits.

    Examples of tackling externalities: Tradable emissions permits

    Another market-based solution to address the externality problem of pollution is tradable emissions permits.

    Tradable emissions permits are licenses issued to emitters allowing them to pollute to a certain quantity that can be bought and sold on the emissions trading market.

    The tradable aspect of the permit allows a transaction exchange where firms that find it easier to reduce pollution can sell some of their permits to other firms struggling with emission reduction. This mechanism creates a market where economic actors buy and sell rights to pollute. Therefore, firms with government-issued permits can cut their emissions way below their permits threshold and have some excess permits to sell at a market rate to firms needing pollution permits. As with emission taxes, tradable permits incentivize polluters to internalize the externality.

    Suppose the market rate for a permit to emit one ton of carbon monoxide is $10. In that case, every plant has the incentive to limit its emissions to the level where its marginal benefit of emitting another ton of carbon monoxide is $10. If a plant must pay $10 for the right to emit an additional ton of carbon monoxide, it faces the same incentive as a plant facing an emission tax of $10. So, by not emitting a ton of carbon monoxide, a plant frees up a permit it can sell for $10; therefore, the opportunity cost of a ton of emissions to the plant's owner is $10.

    Polluters will always pick tradable permits or emission taxes over environmental standards because the cost-saving benefits encourage them to do the right thing: invest in emission reduction technology that lowers emission levels to socially optimal quantities. However, the shortcoming of these tradable permits is difficulty in determining the optimal pollution quantity. For instance, there is always a risk of issuing permits to polluters who lie about their data, abuse the process and sell the permits to several other emitters.

    Public policy dealing with positive and negative externalities

    Public policy dealing with positive and negative externalities would depend on the type of externality. Economists categorize externalities into positive and negative externalities. The meaning is straightforward: positive externalities are external benefits, and negative externalities are external costs.

    Positive externalities: private versus social benefits

    A common policy tool for the government to deal with positive externalities is subsidies.

    Positive externalities are external benefits that an activity has on others that the economic actor doesn't take into account.

    A Pigouvian subsidy is a payment from the government that aims to correct for the external benefits that an activity generates.

    Take condoms for example. The potential users would consider the benefits of not contracting STDs themselves, but there are additional benefits to society as well, such as reducing the likelihood of an epidemic of STDs. The private economic actors only consider their private benefits, resulting in the underutilization of condoms. Therefore, the government may choose to subsidize the production of condoms to correct for the positive externalities so that more people would use condoms.

    The marginal benefit to the condom user is a marginal private benefit (MPB). The marginal benefit to society as a whole is the marginal social benefit (MSB). The difference between the MPB and MSB is the marginal external benefit (MEB). Therefore,MSB =MPB +MEB. The key lesson here is that public policy is necessary to take the marginal social benefit into account. A free-market economy has no incentive to engage in production or consumption that increases external benefits.

    externalities and public policy optimal pigouvian subsidy studysmarterFig 2. - Optimal Pigouvian subsidy

    Figure 2 above shows a positive externality that is being regulated by a subsidy. As there are external benefits associated to this particular good, the government provides a subsidy to increase the consumption of this good thereby eliminating deadweight loss (represented by the red triangular area). Due to the subsidy, the MPB curve shifts to where the MSB curve is, thereby increasing quantity demanded from Q0 to Qsubsidy. The optimal Pigouvian subsidy is equal to the size of the marginal external benefit and allows to lower the price that consumers pay (from P0 to Pc), whilst raising the price that producers receive (from P0 to Pp). The subsidy expense is represented by the blue rectangular area and is the cost of public policy to deal with a positive externality.

    Negative externalities: private versus social cost

    Common policy tools to deal with negative externalities include regulations and taxes.

    Negative externalities are external costs that an activity has on others that the economic actor doesn't take into account.

    A Pigouvian tax is a tax that aims to correct for the external costs that an activity generates.

    An activity like cement production produces a large amount of pollution. The firm would only consider the marginal private cost (MPC) - the marginal cost of producing an extra unit involving all the production inputs. But the marginal cost to society as a whole is marginal social cost (MSC), which includes the marginal external cost (MEC) in addition to the marginal private cost: MSC=MPC+MEC.

    In this scenario, the government may choose to impose regulations that limit how much pollution the firm can emit. Alternatively, the government can impose an emission tax that is equal to the marginal external cost or implement a tradeable permit system with the target unit price that is equal to the marginal external cost of pollution.

    externalities and public policy optimal pigouvian tax studysmarterFig 3. - Optimal Pigouvian tax

    Figure 3 above shows a negative externality that is being regulated by a tax. As there are external costs associated to this particular good, the government imposes a tax to decrease the consumption of this good thereby eliminating deadweight loss (represented by the red triangular area). Due to the tax, the MPC curve shifts to where the MSC curve is, thereby decreasing quantity demanded from Q0 to Qtax. The optimal Pigouvian tax is equal to the size of the marginal external cost and allows to increase the price that consumers pay (from P0 to Pc), whilst lowering the price that producers receive (from P0 to Pp). The tax revenue is represented by the green rectangular area.

    Externalities and Public Policy - Key takeaways

    • Public policy dealing with externalities refers to laws, regulations, ordinances, and programs that aim to correct the externalities and achieve socially desirable outcomes.

    • Externalities arise when one economic actor's production or consumption actions make another economic actor bear indirect costs or receive indirect benefits of that action

    • Environmental standards are rules that regulate what firms and consumers have to do with regard to pollution. Examples include regulations on car exhaust, wastewater treatment, and emission standards for factories.
    • An emissions tax puts a price on pollution that depends on the amount of pollution that a firm emits.
    • Tradable Emissions Permits are licenses issued to emitters allowing them to pollute to a certain quantity that can be bought and sold.
    • Public policy is necessary to correct for externalities when economic actors in a free-market economy have no incentives to take external benefits or costs of their actions into account.
    Frequently Asked Questions about Externalities and Public Policy

    What are externalities and public policies?

    Public policy dealing with externalities refers to laws, regulations, ordinances, and programs that aim to correct the externalities and achieve socially desirable outcomes. 

    What are postive externalities?

    Positive externalities are external benefits that an activity has on others that the economic actor doesn't take into account. 

    What are negative externalities?

    Negative externalities are external costs that an activity has on others that the economic actor doesn't take into account.

    How to deal with externalities?

    The government can impose regulations, subsidies, and taxes to try and correct for the externalities.

    What are the effects of externalities in the market economy?

    If externalities are left unchecked, the market will produce an outcome that is not socially optimal and lead to market failures.

    Test your knowledge with multiple choice flashcards

    Fill the blanks in the following definition:Externalities arise when one economic actor's production or consumption actions make another economic actor bear ... costs or receive ... benefits of that action

    The U.S. legislature has been actively shaping public policy around environmental protection guidelines. Who does spearhead this government effort through federal and state programs?

    Fill the blank in the following definition:... puts a price on pollution that depends on the amount of pollution that a firm emits.

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    Team Externalities and Public Policy Teachers

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