Three Government Policies Towards Externalities

Updated Jun 26, 2020

Negative externalities often cause markets to fail, i.e. to reach an inefficient outcome for society as a whole. When that happens, the government can respond in one of two ways. It can use command-and-control policies to directly regulate problematic behavior, or it can use market-based policies to provide incentives that will lead individuals and firms to solve the problems on their own. Within this spectrum, we can identify three main types of government policies towards externalities: regulation, Pigovian taxes, and tradable pollution permits.

Regulation

The government can reduce the effects of externalities by passing new laws that directly regulate problematic behavior. This is a command-and-control approach that works well for simple and/or extreme cases of externalities. That means, regulations are often used by the government in cases where the external costs far outweigh the individual benefits (to the polluters).

For example, in most countries, it’s prohibited by law to dump toxic waste into rivers or lakes. Of course, the pollution of the water supply can have horrendous effects on the population, while the benefits to the polluters are negligible from society’s point of view. Therefore it makes perfect sense to prevent such behavior by law.

However, regulation becomes more difficult when the externalities aren’t quite that obvious. For instance, the regulation of harmful CO₂ emissions is much more difficult. Eliminating all CO₂ emissions would force the government to shut down virtually all factories and prohibit almost all forms of transport. Needless to say, that’s not an option.

Hence, most regulations are the result of a well-informed cost/benefit analysis to decide what levels and types of pollution are tolerable. In many cases, this results in laws that either (a) set a maximum level of pollution that may be emitted or (b) define the technological standards that have to be used in production processes.

Pigovian Taxes

Another policy the government can use to internalize externalities is to impose taxes. Taxes on market activities that generate negative externalities are called Pigovian taxes (named after economist Arthur Pigou, who first introduced the idea). Unlike regulations, Pigovian taxes are market-based policies. That means, they provide economic incentives (e.g. lower costs) for individuals and companies to change their behavior to reduce the effects of negative externalities. Or if you look at it from the other way around, taxes put a price on the right to pollute.

To see how this works, let’s look at an example. Assume, the government wants to reduce harmful CO₂ emissions. To do this it imposes a tax of USD 1,000 for every ton of CO₂ firms emit. Now the firms face additional costs for every ton of CO₂ they produce. As a consequence, they have an incentive to reduce their  CO₂ emissions, because they can lower their tax burden if they manage to do so.

In most cases, economists prefer taxes over regulations. The reason for this is that taxes are generally more flexible. That is, regulations typically set a maximum level of pollution that all firms must adhere to, regardless of the costs they face to do so. By contrast, taxes also provide incentives for companies to reduce emissions below that maximum level, because this allows them to save money on taxes. Meanwhile, companies that find it hard to reduce their emissions can still operate as long as they are able to carry the additional tax burden. Thus, essentially taxes allow companies to pay for the right to pollute or get paid for reducing pollution.

What sets Pigovian taxes apart from most other taxes is that they don’t reduce social efficiency. They do the exact opposite, in fact. Pigovian taxes are designed to internalize socially inefficient externalities. So by putting a price on pollution, they generate revenue for the government while increasing social efficiency at the same time. As a result, Pigovian taxes are usually just as effective as regulations but more efficient.

Please note: Although we focus on negative externalities in this article, similar policies can be applied to positive externalities. In that case, however, the government does not impose taxes but instead provides subsidies to encourage certain behavior. 

Tradable Pollution Permits

The third policy to reduce the effects of negative externalities is the issuance of a limited number of tradable pollution permits, that give firms a legal right to emit a certain amount of pollution (e.g. 100 tons of  CO₂). This approach is a bit of a mix between command-and-control and market-based policies. On one hand, the government sets a maximum amount of pollution that is binding for all companies. On the other hand, the firms are free to trade permits (i.e. they can voluntarily transfer their right to pollute) and thereby increase or decrease their individual limit of pollution within the given range.

For example, let’s revisit our example from above. Assume, the government wants to reduce the maximum amount of CO₂ emissions to 1,000,000 tons per year. Instead of passing a law that directly limits emissions per company, it issues 10,000 tradable pollution permits. Each permit allows the holder to emit 100 tons of CO₂. By doing this, the government essentially creates a new scarce resource. This results in a market for pollution permits where firms can buy and sell their right to pollute. Firms who can easily reduce their CO₂ emissions will sell some of their permits, while others will need to buy more because they cannot reduce their emissions any further.

Although they are pretty similar to Pigovian taxes, pollution permits can sometimes be a better choice for the government. Particularly, when the government wants to reach a certain level of maximum pollution but does not know the tax rate to reach that goal. In this case, it can simply issue a fixed number of permits and let the market determine the price.

In a Nutshell

Negative externalities often cause markets to fail. When that happens, the government can respond by using one of three types of policies: regulation, Pigovian taxes, and tradable pollution permits. Regulation allows the government to reduce externalities by passing new laws that directly regulate problematic behavior. Pigovian taxes are taxes designed to change the behavior of firms or individuals to reduce negative externalities. And last but not least, tradable pollution permits give firms legal rights to emit certain amounts of pollution within a given range, thus reducing the effects of externalities.