Controlling Externalities

Controlling Externalities:

Since the 1960ies (at least) most developed countries’ governments have introduced laws and started special supervising agencies to control negative production externalities. The most common method has been to regulate the activity directly; by setting so called emission or effluent standards (we say emissions in the case of air pollution and effluents in the case of water pollution). If there is a one-to-one relationship between emissions and output, an emission standard would be the same thing as to regulate how much each firm could produce. Hence, it would be the same thing as a quantity regulation of the good, whose production causes the negative externality. Often it is the case that how much to pollute is a matter of choice for the producer/firm. If the regulation is in the form a an emission standard, the firm can switch over to a less polluting technology, which maybe was more expensive to use before the standard was introduced, but now is profitable to use since the firm can produce more of the good and still meet the standard. Alternatively, the firm can use the old technology but add some extra stages to the production process which cleans up (partially or totally) the pollute substances, before they are released into the environment and causes damages to others.

A more recent trend has been to use so called emission fees (or effluent charges), which are essentially taxes on pollution. Given the technology in use the production of the good results in a given marginal damage. An optimal emission-fee would put a tax per unit of the good produced equal to the marginal damage. This would shift the MPC curve up by τ = MD, and the firm’s marginal cost curve will now coincide with the society’s marginal cost curve. The external effect has been internalized.

In externalities, the marginal damage was constant, but as mentioned above, it may also be an increasing function of output. The Pareto-efficient level of output is still at the level where the demand curve intersects with the MPC-curve. The only difference is that the optimal tax-rate is not constant and independent of the quantity, but it is equal to the marginal damage at the optimal level: τ = MD(q1).

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