Government intervention and negative production externalities
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Governments frequently use regulations to overcome market failures caused by production externalities. The government might intervene by setting standards that restrict the amount of pollution that can be legally dumped by a firm.
The government may pass laws that directly target the negative externality itself (rather than the underlying activity that leads to the externality). For example, by setting standards that restrict the amount of pollution that can be legally dumped by a factory.
Unlike indirect taxation and regulations, pollution permits are a free market solution as they can be bought and sold. Polluting firms are given a certain number of ‘permits to pollute’ over a given time period. If a firm emits a lower level of pollution, it can sell its spare permits in the market to firms needing to buy more permits since they have used up those allocated to them.
The government impose an indirect tax, which is ideally equal to the marginal external cost (MEC). This tax is added to the cost of producing the product; the supply curve S2 is now equal to the MPC plus this tax. The price would rises to P2 and quantity falls to Q2 bringing about the socially optimum level of consumption. The effect of the negative externality is now internalised within the market.