Public Solutions to Externalities - Online Tutor, Practice Problems & Exam Prep

Governments address externalities—costs or benefits affecting third parties—through command and control policies or market-based solutions. Command policies mandate behaviors, like compulsory education or pollution restrictions. Market-based solutions include Pigovian taxes, which align private costs with social costs, and subsidies that encourage beneficial activities. Additionally, pollution permits create a market for pollution rights, allowing firms to trade based on their needs. These strategies aim to internalize externalities, ensuring efficient resource allocation and maximizing societal benefits.

Public Solutions to Externalities:Command-and-Control Policies and Corrective Pigovian Taxes and Subsidies

Now let's see how the government can step in and help provide solutions to externalities. So, we saw these externalities, right? These are costs or benefits that are imposed on people outside the transaction, right? So, we'll see things like pollution, vaccinations, right? Less contagious populations, things like that. So, what we're going to see now, right, we had those graphs where there were these extra costs or extra benefits not included in the market, and what we want to do is we want to internalize these externalities, right? So, this is a phrase that we use and when we say internalize, we want to bring that cost or that benefit from the externality into the market transaction, right? So, we want the people in the transaction to be accounting for this extra cost or benefit, okay? So it's going to force that full cost or benefit into the market transaction, okay? And we're going to see this for public solutions as well as private. Once we get to private solutions in other videos, we're going to be internalizing these externalities, okay? So let's see how the government can step in and do that.

The first type of thing the government can do is these command and control policies. This is where the government just puts its foot down and says you have to do this or you can't do this, right? It just makes a law. This is the way it has to be done. They're going to require or forbid certain behavior, right? So, on the positive side, right, in the idea of a positive externality, we have been talking about education having these external benefits, right? And the market itself isn't going to take account of these external benefits, so the government steps in and says hey, everybody has to get educated, right? You're going to force this grade school education on everybody because it knows that there's going to be this benefit to society by educating these people, right? So that's kind of a command and control, right? Requiring the education or, how about on the other side, right, in this negative externality, right, where there's this dumping of chemicals into a river by a factory or something, the government can just step in and say hey, you're not allowed to do that, you're not allowed to dump chemicals in the river and then they're going to have to figure out some way to safely get rid of the chemicals, right? They're going to take on the cost to safely dispose of the chemicals. Or the government could also require maybe some sort of like filter system be installed that gets rid of the chemicals as well. In either case, right, the company now has to take on the cost of dealing with those chemicals, right? So that's the first way the government can take action, right? They just say this is the way it has to be or the government can, instill these market-based policies, right? So, before the government was command and control. In this case, the government's either going to implement these corrective taxes, so they're going to put in a tax or a subsidy or they're going to have these quantity limits. They're going to set a limit on quantity. Okay? So we're going to talk about both of these. We're going to talk first in this video we'll spend most of our time talking about these corrective taxes and subsidies, okay? So let's go ahead and jump into that and that's going to be most of the graphs here.

Alright, let's start here with these corrective taxes and what they're also called, is these Pigovian taxes. The reason they have this name is because there was this guy Pigot who won a Nobel Prize for figuring this out. He won a Nobel Prize for figuring out how taxes and subsidies can help us solve problems with externalities. So, his idea, his Nobel Prize-winning idea was to impose a tax or a subsidy equal to the amount of the externality. So, you can imagine if we can quantify this externality, what is the cost of this pollution to society or what is the benefit of this education? We can essentially put in a tax or a subsidy to get us to that correct quantity, right? So what we've seen when we first started talking about these externalities on the graph, we saw that we were not efficient, right? We were at some point where we were overproducing or under-producing because we weren't taking into account the full cost and full benefit to society, right? So first in this negative externality case, right, we had the idea that, if this was our demand curve D1 and this was S1 up here, right, this represented those private costs, right, this was the supply curve that we're used to, right, That it's just the cost the supplier takes into account when he produces the paper. However, when we think of all the costs we include the cost of the pollution, right? It could send us somewhere out here, right? Let's say that was the cost of the pollution to society, that extra cost is added in there now. So that takes us to S2 which was our marginal social cost curve, right? And on that marginal social cost curve all of our costs are included. So we found that our true equilibrium should have been over here, right? This should have been the equilibrium and this should have been the quantity of paper produced over here, Q star where the market was producing here at q I'm going to put M for market, right? The market was producing this higher_quantity. So what can the government do to get us down to that_quantity, right? We were talking about taxes and subsidies. In this case, a tax is what's going to get us to this_quantity. So if you guys remember from when we were talking about taxes, taxes are going to lower our_quantity, right? And that's because the tax puts this difference between the price the buyers pay and the price the sellers receive. So if we were to put a tax in right here equal to the amount of the cost of pollution which by the way the difference between these two curves right here, this length, this is the cost of the pollution. Cost of pollution, right? That's that external cost is that difference between those two curves because that first curve had all our other costs and then we just added one cost, the cost of pollution, and it got us to that other curve. Cool, so this green line I just drew represents an amount of tax, right? So if we were to take SimpleName

Public Solutions to Externalities:Quantity Limits

Alright, so the other solution a government can provide here in the market is a quantity limitation, right? So this is number 2 from above, right? We talked about in the previous video where we were discussing corrective taxes and subsidies, now let's talk about the quantity limits. And that's going to be this idea of pollution permits, right? What we've noticed so far is that there's going to be some amount of pollution that is efficient for society, right? There's going to be this equilibrium amount of pollution and we saw how we could deal with that with taxes. On the left-hand side here we have the idea of a tax being put into this market for pollution rights, and this tax was the amount that we thought was correct from our graph above where we put our marginal social cost. This tax was the amount that got us to the efficient amount of pollution. But there's another way to get there too, right? If the government can estimate the amount of pollution, if they say, 'hey the correct equilibrium amount of pollution is 10,000 tons of pollution a year or whatever, I don't know.' These 10,000 tons that they set, if that's the amount they want, well then they could just make permits that they can sell. They can sell 10,000 permits that each give you the right for 1 ton of pollution, right? So there's 1 ton, it's almost like you have a pollution money. There are going to be these 10,000 permits that allow you to pollute 1 ton of pollution and that's going to be this equilibrium quantity here, Q*, right? This Q* that is that quantity that the government thought was the equilibrium. So they're going to allow pollution permits up to that amount and that's going to be the supply, that's why you see this perfectly vertical line, is because that is the supply of pollution permits. There are 10,000 pollution permits regardless of the price. At this quantity of 10,000 pollution permits regardless of the price, this is our price axis and our quantity axis. What is going to happen is we're going to find the place where those 10,000 pollution permits touch our demand curve and we are going to get a price for these pollution permits. And this price should ideally be the same amount as the tax. So we would expect from our example that these would end up being $10 right? In our previous example on the left, we ended up using this number, that $10 was the correct amount of tax per amount of pollution. So in this case, we have the same demand curve except now we just set the quantity limit and the price is what got found out in the market. You could imagine that there are going to be different companies buying and selling pollution permits based on their need to pollute, right? So maybe this paper company doesn't need the permits as much as maybe a steel company, right? The steel company pollutes a lot more and they might be willing to buy some of the permits from the paper company. So now we create this extra market for these permits, right? Another way to deal with these externalities is to create a market, another market that's going to deal with the externality, right? So in this case we've got a market for these pollution permits and then the trading of the permits is going to find the equilibrium price, right? Because there's only a certain amount of permits, there's only going to be this much pollution, how much do you want to pay for a share of that pollution, right? So that's another way that the government can get involved and deal with externalities, right? So they're going to either do that command and control, right? Where they're just going to say you've got to do it this way, you're required to do this, we forbid this action, or they're going to get involved in the market with these taxes, these subsidies, or these tradable pollution permits. They're going to set these kinds of quantity limitations. So any of those are ways that the government can get involved. Alright. That's about it here, let's go ahead and do some practice problems before we move on to the next video. Okay, let's go ahead and do that now.

Use this diagram to answer the following questions. PD is private demand. SD is social demand. 

Based on the figure above, an unregulated market would produce: 

• A. 100 units
• B. 200 units
• C. 300 units
• D. 400 units

Use this diagram to answer the following questions. PD is private demand. SD is social demand. 

The figure above contains: 

• A. A positive externality
• B. A negative externality
• C. Both positive and negative externalities
• D. No externalities

Use this diagram to answer the following questions. PD is private demand. SD is social demand. 

A per-unit _______________________ would result in the production of the socially optimal quantity. 

• A. Tax of $10
• B. Tax of $20
• C. Subsidy of $10
• D. Subsidy of $20

Here’s what students ask on this topic:

What are Pigovian taxes and how do they help address externalities?

Pigovian taxes, named after economist Arthur Pigou, are taxes imposed on activities that generate negative externalities, such as pollution. The tax is set equal to the external cost of the negative externality. By doing so, it aligns the private cost of the activity with its social cost, thereby internalizing the externality. This encourages producers to reduce the harmful activity to the socially optimal level. For example, a factory that pollutes would face a tax equivalent to the societal cost of the pollution, incentivizing it to reduce emissions or invest in cleaner technologies.

How do subsidies work to correct positive externalities?

Subsidies are financial incentives provided by the government to encourage activities that generate positive externalities, such as education or vaccinations. These activities benefit not only the individual but also society at large. By subsidizing these activities, the government lowers the cost for individuals, encouraging more participation. For instance, subsidizing education reduces tuition fees, making it more accessible and increasing the overall education level in society, which has widespread benefits like a more skilled workforce and lower crime rates.

What are command and control policies in the context of externalities?

Command and control policies are regulatory measures where the government mandates specific behaviors to address externalities. These policies can either require or forbid certain actions. For example, the government may impose regulations that limit the amount of pollutants a factory can emit or mandate that all children must attend school. These policies are straightforward but can be inflexible and may not always achieve the most cost-effective outcomes compared to market-based solutions like taxes or subsidies.

What are pollution permits and how do they function?

Pollution permits, also known as cap-and-trade systems, are a market-based approach to controlling pollution. The government sets a cap on the total amount of pollution allowed and issues permits that grant the right to emit a specific amount. Companies can buy and sell these permits, creating a market for pollution rights. This system incentivizes companies to reduce emissions; those that can do so at a lower cost can sell their excess permits to others. The cap ensures that the overall pollution level remains within the desired limit, promoting environmental sustainability.

How do corrective taxes and subsidies differ from quantity limitations in addressing externalities?

Corrective taxes and subsidies adjust the cost of activities to reflect their externalities, encouraging market participants to change their behavior. Taxes are used for negative externalities, increasing the cost of harmful activities, while subsidies are used for positive externalities, reducing the cost of beneficial activities. Quantity limitations, on the other hand, directly control the amount of the externality by setting a cap, such as through pollution permits. While taxes and subsidies influence behavior through price signals, quantity limitations set a hard limit on the externality, ensuring it does not exceed a certain level.