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Table of Contents

  1. Topic pack - Microeconomics - introduction
  2. 1.1 Competitive Markets: Demand and Supply
  3. 1.1 Competitive Markets: Demand and Supply - notes
  4. 1.1 Competitive markets - questions
  5. 1.1 Competitive markets - simulations and activities
  6. 1.2 Elasticities
  7. 1.2 Elasticities - notes
  8. Section 1.2 Elasticities - questions
  9. Section 1.2 Elasticities - simulations and activities
  10. 1.3 Government intervention
  11. 1.3 Government Intervention - notes
  12. 1.3 Government intervention - questions
  13. 1.3 Government intervention - simulations and activities
  14. 1.4 Market failure
  15. 1.4 Market failure - notes
    1. The meaning of externalities
    2. Types of externalities
    3. How do externalities affect allocative efficiency?
    4. Negative externalities of production
    5. Negative externalities of consumption
    6. The economic theory of traffic congestion
    7. Demerit goods
    8. Government responses - demerit goods
    9. Possible government responses to externalities
    10. Direct government provision
    11. Extension of property rights
    12. Taxes and subsidies
    13. Tradeable pollution rights
    14. Regulation, legislation and direct controls
    15. Positive externalities of production
    16. Positive externalities of consumption
    17. Merit goods
    18. Why might merit goods be underprovided by the market?
    19. Government responses - merit goods
    20. Public goods
    21. Common access resources & sustainability
    22. The tragedy of the Commons
    23. Common access resources in practice
    24. Sustainability
    25. Threats to Sustainability
    26. The threat to sustainability from the use of fossil fuels
    27. The threat to sustainability from poverty
    28. Government responses to threats to sustainability
    29. Cap and Trade Schemes
    30. Promoting Clean Technologies
    31. The 'dirty side' of cleaner technologies
    32. International responses to threats to sustainability
    33. Asymmetric information
    34. Abuse of monopoly power
    35. Inequality
  16. Section 1.4 Market failure - questions
  17. Section 1.4 Market failure - simulations and activities
  18. 1.5 Theory of the firm
  19. 1.5 Theory of the firm - notes (HL only)
  20. Section 1.5 Theory of the firm - questions
  21. Section 1.5 Theory of the firm - simulations and activities
  22. Print View

Possible government responses to externalities


The outstanding characteristic of a market economy is that production does not occur as a result of some grand, master plan; rather, it is the result of the pulls and pushes of supply and demand, of the numerous uncoordinated decisions of individuals and firms.
Adam Smith

As individuals are assumed to seek to maximise their own satisfaction, and firms maximise their own profits, decisions made are likely to be strictly on the basis of private costs and benefits only. Herein lies the problem: unless the full social costs and benefits of production and consumption decisions are taken into account, so that MSC is equated to MSB, social inefficiency and a misallocation of society's scarce resources will result.

So, what measures can a government take to rectify such inefficiency, and how successful is it likely to be? As is the case with most important questions in economics, a range of answers is possible, depending largely on the political perspective of the respondent. At one end of the spectrum, governments could 'leave well alone', essentially not interfering with markets but trying to gently persuade firms and individuals to modify their behaviour. At the other extreme, the market could be completely replaced by direct government provision, and in between various policy options are possible. We now turn to an examination of some of these options.

Summary of possible types of policies:
  • Direct provision of goods and services - this means the government providing the good or service themselves, perhaps through state-owned or nationalised industries.
  • The extension of property rights - this means giving people more right of ownership over their immediate environment, so that they can enforce environmental and other standards.
  • Taxes and subsidies - where an activity causes negative externalities it could be taxed and where there are positive externalities, it could be subsidised.
  • Tradeable pollution rights - this involves allowing companies to pollute a certain amount (a 'permit to pollute') but then creating a market for the permits, so that if they pollute more than the allowance they have to buy extra permits. However, if they pollute less, then they can sell their surplus permits.
  • Regulation, legislation and direct controls - this involves setting legal limits or regulations to prevent negative externalities or perhaps to reduce their impact.

Perhaps there is one more alternative - the use of 'nudge theory', rather than coercion, to persuade people to change their behaviour.

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Changing behaviour with a gentle nudge

Can a nudge replace a congestion tax?