Market failure and government intervention
Correction of market failure arising from externalities
Let us consider the case where a private firm is polluting the environment. This pollution is an example of a social cost. The result is over-production. There is a loss of social benefit. This is called the deadweight loss.
The deadweight loss is defined to be the total excess of social cost over social benefit arising from over-production. It is represented graphically by the shaded triangle in the diagram above.
The deadweight loss is an example of market failure – in this case, the market fails to provide the allocatively efficient output because the external costs (and benefits) of the good are not “seen” by the producer.
To correct the market failure resulting from over-production, governments aim to pass the cost of over-production onto the firms that produce it. This internalises the externalities, and means that all the costs are borne by the producer. It is the principle that the “polluter pays”. Governments can either
Methods (2) and (3) are known as “market methods”, since they use the market to correct the market failure. Most economists prefer market methods to ensure that the quantity produced is allocatively efficient.
When a tax is imposed it is aimed to set the tax at the level that raises prices so that the quantity produced is reduced to the optimum amount. [See figure 2.]
In figure 2, the dotted line represents the supply curve after the imposition of a tax. The result is that output is reduced from q2 to q1 and the deadweight loss is eliminated.
However, the policy of imposing taxes only works if external costs can be accurately calculated, and if there are further changes in demand, the tax does not automatically respond to the change, resulting in a further market failure developing.
Figure 1. Market failure resulting in overproduction.
MPC = Marginal private cost (also equal to the industry supply curve)
MXC = Marginal external cost – the cost of the pollution in this example
MSC = Marginal social cost = MPC + MXC
MSB = Marginal social benefit (also equal to the industry demand schedule)
Figure 2. Use of taxation to "correct" market failure.
For this reason, the use of tradable pollution permits is now advocated as a means of passing the cost of pollution on to the producers in a way that can adjust to market conditions. Where there are social benefits that outweigh the social costs, then the government may intervene to correct the market failure by (1) State provision, (2) Providing subsidies, or (3) Providing information.
Tradable pollution permits
The American 1990 Clean Air Act required America’s coal-burning power stations to halve by 2000 their emissions of sulphur dioxide which results in acid rain. However, it was anticipated that some companies would succeed in reducing sulphur emissions below the figure of 50%. Because of this the act also permits those companies who more than halve their emissions to sell the right to pollute to other companies that do not succeed in halving their emissions. These permissions to pollute are called “tradable pollution allowances”.
Thus a market in pollution allowances is created. The price of the pollution allowances will be determined in the usual way by supply and demand. The supply of pollution allowances derives from those companies that over-comply with the regulations and more than halve their emissions; and the demand for pollution allowances derives from those companies that do not comply with the regulations in part or in full. To see how this works, the clean air act effectively imposes an increased cost on the power-generating industry – the cost of installing new equipment to reduce the sulphur emissions. This presumably brings the overall output of energy back to the allocatively efficient level.
Figure 3. Use of tradable pollution permits to correct market failure.
However, a further increase in demand could lead to the creation of further allocative inefficiency, since the graph of the marginal social cost (MSC) is not parallel to the new supply curve (S’). [See figure 4.]
In figure 4, the shaded area shows a new deadweight loss developing. However, the market in pollution permits should automatically correct this developing market imperfection. The increased demand for power will create increased pressure to pollute. However, the total emissions is capped. Therefore, either the demand for pollution permits will increase or the supply of them will decrease, or, most likely, both. Either way, the price of pollution permits will go up.
Figure 4. Development of new deadweight loss in a market corrected by the use of tradeable permits.