When an externality causes a market to reach an inefficient allocation of resources, the government can respond in one of the two ways. Command and control policies regulate directly. Market based policies provide incentives so that private decision makers will choose to solve the problems.
Command and Control Policies: Regulation
The government can remedy an externality by making certain behaviors either required or forbidden. For example it is a crime to dump poisonous chemicals into the water supply. In this case, the external costs to society far exceed the benefits to the polluter. The government therefore institutes a command and control policy that prohibits this act altogether
In most cases of pollution however, the situation is not this simple . Despite that stated goals of some environmentalists it would be impossible to prohibit all polluting activity. For example virtually all forms of transportation – even the horse – produce some undesirable polluting by products. But it would not be sensible for the government to ban all transportation. Thus, instead of trying to eradicate pollution entirely society has to weigh the costs and benefits to decide the kinds and quantities of pollution it will allow. In the US, the Environmental Protection Agency (EPA) is the government agency with the task of developing and enforcing regulations aimed at protecting the environment.
Environmental regulations can take many forms. Sometimes the EPA dictates a maximum level of pollution that a factory may emit. Other times the EPA requires that firms adopt a particular technology to reduce emissions. In all cases, to design good rules, the government regulators need to know the details about specific industries and about the alternative technologies that those industries could adopt. This information is often difficult for government regulators to obtain.
Correctives taxes and subsidies:
Instead of regulating behavior in response to an externality the government can use market based policies to align private incentives with social efficiency. For instance we saw, earlier the government can internalize the externality by taxing activities that have negative externalities and subsidizing activities that have positive externalities. Taxes enacted to deal with the effects of negative externalities are called correctives taxes. They are also called Pigovian taxes after economists Arthur Pigou (1877-1959) an early advocate of their use. An ideal corrective tax would equal the external cost from an activity with negative externalities and an ideal corrective subsidy would equal the external benefits from an activity with positive externalities.
Economists usually prefer corrective taxes to regulations as a way to deal with pollution because they can reduce pollution at a lower cost to society.
Suppose that two factors – a paper mill and a steel mill are each dumping 500 tons of glop into a river each year. The EPA decides that it wants to reduce the amount of pollution. It considers two solutions:
1) Regulation: The EPA could tell each factory to reduce its pollution to 300 tons of glop per year.
2) Corrective taxes: The EPA could levy a tax on each factory of $50,000 for each ton of glop it emits.
The regulations would dictate a level of pollution whereas the tax would give factory owners an economic incentive to reduce pollution. Which solution do you think is better?
Most economists would prefer the tax. They would first point out that a tax is just as effective as a regulation in reducing the overall level of pollution. The EPA can achieve whatever level of pollution it wants by setting the tax at the appropriate level. The higher the tax, the larger the reduction in pollution indeed, if the tax is high enough the factories will close down altogether reducting pollution to zero.
The reasons economists would prefer the tax is that it reduces pollution more efficiently. The regulations requires each factory to reduce pollution by the same amount but an equal reduction is not necessarily the least expensive way to clean up the water. It is possible that the paper mill can reduce pollution at a lower cost than the steel mill. If so, the paper mill would respond to the tax by reducing pollution substantially to avoid the tax, whereas the steel mill would respond by reducing pollution less and paying the tax.
In essence the corrective tax places a price on the right to pollute. Just as markets allocate goods to those buyers who value them most highly a corrective taxes allocates pollution to those factories that face the highest cost of reducing it. Whatsoever the level of pollution the EPA chooses, it can achieve this goal at the lowest total cost using a tax.
Excerpts from Principle of Economics