Reasons for government intervention

We know from the previous chapters that cover externalities along with merit and demerit good that they lead to market failure. Without any government, intervention resources are misallocated and the welfare of a country’s citizens is not maximised. Governments intervene when there is market failure to affect resource allocation and improve the welfare of their country's citizens. Governments do this by trying to move output in markets where there is market failure closer to the socially efficient level where social costs equal social benefits.

Policies for external costs

The market failure associated with negative externalities leads to an over-allocation of resources and a resulting welfare loss to society. The government policies associated with dealing with negative externalities are based on the objective of trying to reduce the market output towards the socially efficient level where marginal social costs equal marginal social benefits.

One of the central problems for any government trying to apply policies to reduce negative externalities and achieve the socially efficient level of output is the problem of measuring external costs and establishing where the socially efficient level of output is. For example, governments know there are negative externalities associated with the consumption of alcohol but it is very difficult to come up with an accurate measure of the extent to which resources are over-allocated in the market. This measurement is further complicated by the existence of positive externalities associated with the market for alcohol such as employment in related industries. 

Demerit goods

Many of the policies used to manage the market failure associated with consumption external costs can be used to deal with similar market failures associated with demerit goods. The application of indirect tax, regulation and demand-reducing policies can all be applied to demerit goods.

Taxation (Pigovian tax)

Tax on production external costs

Where an industry is associated with significant negative externalities governments can impose indirect taxes on producers. An indirect tax adds to business costs causing an increase in the price of the good and leading to a fall in output towards the socially efficient level.  This is illustrated by diagram 2.45, where an energy company pays a specific tax on the electricity it produces.

The tax is called 'Pigovian' because it was developed from the work of the UK economist, Arthur Cecil Pigou who did significant amounts of research on market failure. 

In this example, the tax increases the market price to P1 and moves output from Q to Q1 which is at the socially efficient output at Q*. This removes the welfare loss associated with the electricity industry, although it should be pointed out that in reality achieving the exact socially efficient output is impossible.

Tax on consumption external costs

Tax can also be imposed on negative externalities of consumption. In many countries governments tax cigarettes to reduce their consumption and the associated social costs.  Diagram 2.46 illustrates the impact of an indirect tax on cigarettes. The effect is similar to a tax on good on negative externalities of production, with the price of cigarettes increasing to P1 and the output of cigarettes being reduced from Q to Q* at the socially efficient output. The tax removes the yellow welfare loss triangle.

Advantages of using tax:

• Tax revenue can be used to compensate affected third parties and to pay for the negative consequences of an externality. For example, the tax revenue from cigarettes can be used to pay for some of the healthcare costs of people who smoke.
• Increasing price is an effective way of reducing consumption and production.

Disadvantages of using tax:

• Tax can reduce the welfare of low-income groups where the price of a good is a significant proportion of their income. For example, a tax on petrol can have a significant impact on the incomes of poorer households who rely on their cars.
• Increasing business costs can lead to lower business profits and even business failure. Increasing tax can be particularly significant for small businesses.
• If business costs rise in industries such as energy this could lead to a higher average price level in the economy and increase inflation.
• The tax can make domestic firms uncompetitive on international markets and lead to a fall in exports.
• If business output decreases because of the tax increase it can cause unemployment to rise in an industry.

Regulation

Regulation of production external costs

The government can use legislation to regulate markets associated with external costs. Governments can regulate production externalities by requiring firms to meet certain criteria when they are producing goods and services. For example, airlines flying into international airports are not allowed to land and take off between 23.30 and 0600.  The construction industry is subject to government regulations when it is planning building projects and needs to meet different planning regulations. There are regulations on certain substances such as asbestos that cannot be used in manufacturing processes.

Regulation of consumption external costs

The strictest form of regulation is to make the consumption and production of a good with significant external costs illegal. This is the case with recreational drugs like cocaine and heroin where consumption and production are illegal in most countries.

It is also possible for governments to allow the consumption and production of a good but control the market. Alcohol, for example, is a legal recreational drug but its consumption is controlled in many countries in the form of age restrictions, licensing hours, licensed retailers, restricted consumption in public places, restrictions on advertising and the products need to have health warnings on their packaging.

Advantages of regulation:

• They can be targeted more specifically at a negative externality than taxation. If the main pollutant in the production of a good is a specific chemical, then a regulation can deal more specifically with that problem than a tax.
• Whilst regulations can cause an increase in costs, they are less likely to lead to an increased price than a tax if the firm can comply with the regulation relatively easily.

Disadvantages of regulation:

• The cost of implementing legal restrictions can be significant for governments. For example, governments spend huge amounts of money on their anti-drug law enforcement programmes.
• Parallel markets arise in regulated markets and the goods provided can be in the hands of criminal gangs. This is a particular problem in the recreational drugs market.
• Regulations can drive up business costs increasing prices for consumers. For example, regulations on the burning of fossil fuels and CO2 emissions have increased the cost of electricity.
• Firms can find their way around regulations.
• Businesses often locate production facilities in countries with lower regulations, which adversely affects domestic employment and can move the externality problem to another country.

Tradeable permits

The last 20 years have seen a rise in the market for tradeable permits or cap and trade schemes, which are a market solution to the problem of external costs.  The market for CO2 emission permits has become an increasingly important measure used to control the negative externalities associated with C02 pollution as a contributor to climate change.

The system for carbon trading works in the following way:

• The government sets a total limit on the carbon emissions it will allow from an industry.
• The total of carbon emissions is then divided up amongst producers that emit carbon and they are allocated a CO2 allowance.
• The producers are not allowed to emit more CO2 than their allowance.
• This gives producers in the industry an incentive to reduce their CO2 emissions because they can sell any unused allowance they have to less carbon-efficient producers.
• If the government reduces the number of permits their price and value rise and there is a greater incentive for producers to reduce their emissions.

To be truly successful in addressing climate change the carbon trading system needs to be an international market and the emission limits need to be policed effectively. The current market for CO2 permits is worth about $82 billion.

Advantages of tradeable permits:

• Carbon credits create an incentive system that is more effective at reducing CO2 than a tax that firms need to pay whatever their carbon emissions.
• Using an incentive-based system facilitates innovation and firms develop technology to reduce pollution.

Disadvantages of tradeable permits:

• The system is complicated and expensive to set up and administer.
• The number of permits allowed needs to be tightly controlled at an international level to have any impact on CO2 emissions and some countries may not follow the system.
• The permits add to business costs and lead to higher prices.

Reducing demand

An alternative way of dealing with negative externalities is to reduce the demand for the good associated with the negative externality to the socially optimum level of output. This can be done through government-financed advertising campaigns. Many countries run advertising campaigns that try to persuade people to give up smoking or taking recreational drugs. Similarly, governments run education programs that inform people of the hazards associated with smoking, drinking alcohol and taking recreational drugs.

It is also possible for governments to reduce the demand for goods associated with negative externalities by subsidising products that are substitutes for the ones with the negative externality.  For example, subsidising public transport causes the demand for private car use to fall along with the negative externalities associated with the use of cars.

Diagram 2.47 shows how an effective advertising campaign against drinking alcohol reduces its demand, which in turn reduces the external cost associated with its consumption.  In this example, the welfare loss is removed as D shifts to D1.

Advantages of reducing demand

• Advertising does not add to business costs so the price of goods does not increase.
• For some consumption negative externalities such as cigarettes and alcohol, this approach might be more effective as a long-term solution to the problem because it changes consumer behaviour.

Disadvantages of regulation:

• There is an opportunity cost to the government of paying for advertising, education and subsidies.
• The effectiveness of advertising and educational programmes are difficult to measure and are sometimes questionable.

Policies for external benefits

The market failure associated with positive externalities leads to an under-allocation of resources and a resulting welfare loss because society misses out on the potential welfare gain from producing at the socially efficient output.  The government policies associated with dealing with positive externalities are based on the aim of trying to increase the market output towards the socially efficient level where marginal social costs equal marginal social benefits. One of the central problems for any government trying to apply policies to increase output to achieve the socially efficient level is measuring external benefits and establishing where the socially efficient level of output is.

Merit goods

Government policies aim to encourage the consumption and production of merit goods. This is the same set of policies discussed with positive externalities: subsidy, state provision, regulation, advertising and education are applied to merit goods. 

Subsidies

Subsidies on external benefits of consumption

When positive externalities exist in a market the government aims to increase market output to the socially optimum level.  The payment of a subsidy provides a financial incentive for producers to increase output, and consumers to increase consumption of a good associated with positive externalities.  For example, governments subsidise anti-malarial drugs to make them more affordable in developing countries.

Diagram 2.48 shows the impact of the subsidy on anti-malarial drugs.  Initially, the market output is at Q below the socially efficient level at Q*. There is a potential welfare gain equal to the yellow shaded area.  When the subsidy is added by the government the price falls from P to P1 and output rises to the socially efficient level at Q* and welfare is gained.

Subsidies on production external benefits

By subsidising the production of a good with positive externalities firms are encouraged to increase output towards the socially efficient level.  Subsidies are often paid to firms who locate in areas of industrial decline because the positive externalities of their location help to stimulate regional economic growth. Diagram 2.49 illustrates the effect of a subsidy paid to businesses that locate in an area that has suffered from significant industrial decline. The price falls from P to P1 and output increases to the socially efficient output at Q*.

Advantages of subsidies:

• Subsidies create direct financial incentives that will increase output and capture the welfare gain from external benefits.
• Low-income consumers benefit from lower-priced goods particularly if they are on necessity goods such as healthcare products.
• Producers will be encouraged to increase output which creates employment.

Disadvantages of subsidies:

• There is an opportunity cost to the government of the subsidy in terms of other public services they could have financed.
• The subsidy might take resources away from other products.  A subsidy on, for example, anti-malaria drugs may take resources away from drugs for other illnesses such as HIV
• Subsidies are often paid to high-income groups such as rich people benefiting from subsidised healthcare.
• Subsidies can lead to a welfare loss where inefficient producers are drawn into the market.

State provision

The government could choose to take the provision of merit goods and other goods associated with significant positive externalities into the public sector and provide the goods themselves at the socially efficient level of output.  This is particularly true in the healthcare and education markets where the provision of these merit goods is seen as being so important to society. 

Advantages of state provision:

• Government provision of merit goods is the most direct way of increasing output towards the socially efficient level.
• Many people believe the state is more likely than the private sector to make decisions about the provision of merit goods that are in the public interest.
• Goods can be provided at the price (or zero price) that all households can afford. This is seen as particularly important in healthcare and education.

Disadvantages of state provision:

• The cost of providing state-run healthcare and education is extremely high and carries a significant opportunity cost to the government.
• Some people believe that state provision is less efficient than private-sector provision because state-run organisations experience diseconomies of scale.
• State-run organisations are often subject to considerable political interference which compromises their benefits to society.

Regulation

Governments believe that the consumption of some goods is so crucial to the welfare of individuals in society that the government forces people to consume them.  This is particularly the case with primary and secondary school education where many countries make it compulsory for parents to send their children to school through the law.  This is also the case with car insurance where individuals legally need to own third-party car insurance so people adversely affected by a car accident will be compensated.

Advantages of regulation:

• Laws compel individuals and businesses to make decisions that increase output to the socially efficient level.
• Regulations can be targeted precisely at goods and services with positive externalities.

Disadvantages of regulations:

• There can be significant costs of policing the system and enforcing regulations.
• Regulations add to business costs which can reduce employment and increase prices.
• Some people avoid the regulations and parallel markets can develop.

Increasing demand

Governments can try to increase the demand for goods associated with positive externalities to move production and consumption towards the socially efficient level of output. For example, the state can fund the advertising of things like further education, healthy eating and exercise to increase the demand for goods and services in these markets and increase the resulting external benefits.  Educational programmes can be used to increase the demand for merit goods by informing people of the benefits, for example, of vaccinating against diseases like measles.

Diagram 2.50 illustrates the impact of a government advertising campaign to increase the consumption of fruit and vegetables as part of a healthy living policy. The demand curve for fruit and vegetable shifts to the right and market output increases from Q to Q1 which is closer to the socially efficient output Q*. As a result, some welfare is gained and is shown by the yellow area on the diagram.

Advantages of increasing demand:

• Education and advertising are not as expensive as using subsidies and do not have the management problems of regulation
• The approach can be effective in altering human behaviour which is an effective long-run solution to the under-provision of goods associated with positive externalities.

Disadvantages of increasing demand:

• The opportunity cost to the government of funding advertising and educational programmes.
• It is not always easy to measure the effectiveness of advertising and educational programmes.