Skip to main content

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

Taxes and subsidies

The use of taxes and subsidies to tackle the problem of externalities is a market-based method of control as it works through the price system, i.e. through the impact of changes in prices.

If negative externalities exist, and there is allocative inefficiency at the free market price because MSC is greater than P (price) and overproduction occurs, a solution would be to tax the good. If, on the other hand, the market is under-producing because positive externalities are not being taken into account, it would be appropriate for the government to use a subsidy.


I say `Tax on a good... and you say ...

There are two types of tax which may be applied to address the problem of negative externalities: a tax set equal to each firm's marginal external costs or an environmental or 'green' tax.

The policy of taxing firms according to the marginal external costs that they impose on society can be illustrated using figure 1 below.

In this example we assumed that a firm was dumping waste products into a river. The government would have to assess the cost to society of such an action, and impose a tax on the offending firm equal to the value of the marginal external cost (or negative externality); in this case the tax would internalise the externality by making the polluter pay. The levying of such a tax would shift the supply curve from S to S1,which would increase the market price to OP1, and cause the level of output to fall to OQ1, where P = SMC and allocative efficiency is achieved. Note that both the consumer and the producer pay a share of the tax and their proportionate burden depends on PED as discussed under `who bears the burden of an indirect tax?

Figure 1 Negative externalities - dumping of waste

An environmental tax could be imposed either on a producer responsible for creating pollution, or on the inputs to an industry which have caused environmental damage e.g. carbon producing fuels, which are believed to play the major role in the process of global warming. The aim of a carbon tax on each unit of carbon in fossil fuels would be to: raise the price of those sources of power with high carbon contents, thus encouraging a switching to power sources causing lower CO2 emissions; encourage greater conservation of energy in general; and stimulate the search for more environmentally-friendly technologies.

Issues arising from the tax/subsidy approach - discussion

Advocates of this approach would argue that it permits the forces of demand and supply to operate rather than costly bureaucracy. At the same time generators of negative externalities are induced to 'clean-up their act' because the less pollution they create, the less their tax liability; and conversely, grants and subsidies encourage greater output and consumption of those goods involving net social benefits.

In practice various difficulties are likely to arise:

  • for the tax solution to work in the way indicated in figure 1 above, the exact value of the marginal external cost must be established so that taxes, of exactly the right size can be applied; in reality it is not only extremely difficult to identify external costs, but it also an extremely arbitrary matter trying to ascribe a monetary value to them e.g. how should the emission of black fumes into the air from an industrial chimney be assessed?
  • from an environmental point of view a tax on pollution does not solve the problem, as pollution is still allowed to continue; the tax merely provides a market-led inducement to firms to find cleaner ways of producing so as to reduce their costs; moreover, the unwilling third parties who receive pollution as a negative externality are not in any way compensated.
  • taxation of pollution would require regular monitoring of pollution emissions and as offending firms are likely to be generating different quantities and types of pollution, such monitoring is likely to be administratively complex and very costly.
  • distortions and inefficiencies might arise in terms of the cost of collecting a pollution tax, the inevitable temptation by the less scrupulous to evade paying it altogether and the possibility of an inflationary impact on the price level.