Strengths and limitations of government policies to correct externalities and approaches to managing common pool resources
We have seen that various forms of government intervention in markets may be well-intended but they carry a price tag. This price tag may be in terms of the resulting misallocation of resources and/or financial costs. In addition, there may be issues associated with policy design and the impact on different stakeholders. Different policy options also have relative strengths and limitations depending on the context and the type of market failure.
On this page, we will seek to evaluate the policy options discussed in the previous pages. We will consider their relative strengths and limitations in the light of:
Challenges involved in measuring externalities
Degree of effectiveness
Consequences for different stakeholders
Challenges involved in measuring externalities
Many forms of intervention require the government to measure the extent of the externality in order to be effective. This is particularly true in the case of taxes and subsidies where the theory suggests that the external costs can be 'internalised' by imposing a per unit tax equal to the monetary value of the marginal external cost in the case of negative externalities and granting a per unit subsidy equal to the marginal external benefit in the case of positive externalities. However, measuring externalities is, at best, tricky. This is because of the difficulties involved in quantifying the positive or negative impact on third parties in monetary terms.
Economists can use some statistical methods to estimate the impact of externalities. For example, the output produced by fewer absences from work as a result of increased provision of health care may be estimated by placing a value on the average output produced per day. However, such measures remain estimates (or even ‘guesstimates’). On the other hand, in order for the policy to be effective we need more accurate and precise measures. When such estimates, overstate the external benefit, the government might provide more than the socially optimal level of the subsidy. On the other hand, if the measure understates the benefit to third parties, the government is likely to underspend on the subsidy. Likewise, in the case of taxes, a lower measure of the negative externality will not address the market failure fully while a higher measure will lead to overcorrection at the cost of reduction in the community surplus from the production and consumption of the good.
The problem of measurement of externalities is not limited to taxes and subsidies. In the case of tradable permits, governments have to estimate the optimal level of the pollutant in order to allocate the right amount of permits. The measurement of the optimal level of the pollutant is linked to the measurement of the externality. Even in the case of regulation and legislation, governments need some measure of the extent of the externality in order to make a case for intervention.
The problem of measurement may be further compounded by the fact that externalities may change over time. The damage done by the emission of greenhouse gases to the environment might increase if more trees are also felled during the period resulting in further reductions in the green cover. Policymakers might, therefore, be faced with a moving target of designing appropriate policies.
Degree of effectiveness
Economic policies have varying degrees of effectiveness depending on the nature of the issue, the specific design of the policies, the nature of markets in which the policies are applied, unforeseen effects of implementation and the nature of the policy itself. We consider each one of these factors below:
Nature of the issue
Policy design is a complex task. The choice of the appropriate policy tool depends on the nature of the issue to be addressed and the possible side-effects of the policy. It might not be wise to rely on market-based measures such as awareness creation or taxes and subsidies when the issue is more serious (such as the abuse of hard drugs). Likewise, government provision may be required instead of (or in combination with) other measures in some situations. For instance, in low-income communities people are often unlikely to have the resources to buy health care and education despite understanding their importance.
In the case of negative externalities, sometimes, regulation may be better suited when the administration of taxes is likely to be complex. This is one of the reasons for having closing hours in bars and restaurants to control drunken behaviour rather than increasing the prices of drinks in the evening.
The manner in which a policy is designed can also have an impact on its effectiveness. Often, policies that are too complex may have unforeseen consequences in practice:
“ In 1995, the Netherlands imposed a groundwater tax. It imposed the tax on drinking water companies in order to preserve clean drinking water for future generations. The government allowed too many exemptions, and as a result, 10 companies paid 90% of the tax. These same companies lobbied to end the tax. In 2011, the Dutch government revoked the tax for being fiscally inefficient.”
While both carbon taxes and cap and trade schemes are seen as effective solutions to the problem of negative externalities created by activities that use fossil fuels and damage our environment, most studies show that the current level of carbon prices is too low to have an impact on global warming. Studies have found that in order to leverage carbon prices to meet the goal of the Paris Agreement, carbon prices would have to be in the range of $40-80. The current median price of carbon globally is $15. Thus, while the policies are regarded as appropriate, the policymakers have not been able to calibrate the price to the level required reducing their effectiveness.
Nature of markets
The intrinsic nature of some markets may reduce the effectiveness of policies. When the demand for a good is highly inelastic, the impact of higher prices due to taxes is likely to be limited. In fact, in such cases regulation is likely to be more effective than taxes. Likewise, in cases where the good can be imported easily, the effectiveness of the tax may be reduced by the influx of imports into the market. The same issue of lack of control arises when consumers are able to purchase the good on a black market. In such cases there is an incentive for consumers to shift demand from the (taxed) internal or legal market to the (untaxed) foreign or black markets.
Corruption, bribery and illegal acts to circumvent taxes
The market responds to policies in different ways. Some of these ways are difficult to foresee reducing the effectiveness of policies. This is particularly true when economic agents tend to employ corrupt practices. Writing in the context of the government bans on discharging untreated wastewater into the Citarum river in Indonesia, this article in the Guardian reports:
“According to local activists, despite the bans, many factories continue to discharge waste via concealed pipes. Even if discovered, bribes to the right people ensure they remain.”
Another example is the use of a “defeat device” or a software that can detect if a car is being tested and has the capacity to alter its performance indicators. Such a device was used in diesel engines by Volkswagen in 2015 to cheat emission tests.
There are many examples of tax evasion and tax avoidance by firms. Such responses can reduce and in some cases nullify the effectiveness of policies.
Sometimes policies have a positive impact on some sectors but their net impact in terms of the big picture of environmental concerns may be negative. Such policy failure is witnessed when government regulation in one market increases the demand for another good or service which creates further negative externalities. For instance, a proposal to tax plastic packaging may increase the demand for other materials such as glass, paper and metals which increase the weight of packaging. As a result, transport costs increase leading to a greater consumption of fossil fuels. This is the argument put forth by the detractors of a tax on plastics in the US state of California.
Nature of the policy
Certain forms of intervention are, by their nature, less effective than others. Awareness creation is unlikely to deliver immediate results. Their effects are slow and one can hope to see results only in the long run. We have seen the conditions under which collective self-governance may be effective. When those conditions are not fulfilled, such agreements are likely to fail and not be long-lasting. The nature of the intervention also determines its effectiveness.
Consequences for stakeholders
As discussed earlier, any policy creates winners and losers - let us examine the impact of the policies used in response to externalities and common pool resources on the relevant stakeholders.
Government action such as direct provision and subsidies in the case of positive externalities of production and consumption benefits consumers by reducing prices and making the good more available. This increases consumer welfare. In the case of merit goods. Such benefits increase overall well-being in the long run.
On the other hand, consumers of goods that create negative externalities are likely to suffer when the government chooses to apply taxes, tradable permits or regulations in the market for these goods. The increased costs are passed onto the consumer in the form of higher prices, reducing their consumption and welfare. This is particularly relevant in the case of goods and services with inelastic demand. Increases in the prices of fossil fuels which are inputs into almost all other industries can lead to a cascading rise in prices. Such increases in prices are likely to have a higher impact on low-income consumers who spend a larger proportion of their income. As the increase in prices represents a higher percentage of the income of low-income households, such policies are considered regressive.
However, the above negative effect must be seen in the light of a few other factors:
Taxes on demerit goods that discourage consumption are likely to have a positive impact on the health of the individuals in the long run, thus offsetting some of the short run negative impact.
Some of the regressive impact on poor households can be reduced if the tax revenues are used by the government to alleviate the suffering of the poor. A study based in the UK found that the impact of “sin taxes” on alcohol and sugary drinks may be proportionately more severe on the poor than the rich but this is outweighed by the benefits received by poor households as a result of increased health spending:
"Households with the lowest amount of disposable income would lose £18 a year from increased alcohol taxes but gain £34 in NHS spending, according to the report."
The impact of government policies in response to positive externalities of production and consumption (subsidies) is likely to be positive for producers. The industries engaged in R&D or in the production of renewable energy, for example, are likely to have increased production with the potential for higher profits and future growth.
On the other hand, regulatory policies, taxes and tradable permits in the case of negative externalities and the protection of common pool resources are likely to reduce output, production and profits for producers. The impact of regulation and administrative procedures is expected to be heavier on small businesses who may be unable to cope with the higher costs and the need for greater expertise in managing such procedures. This may even lead to the closure of small businesses. Other unintended consequences may include the inability of businesses to cope with competition in export markets due to higher costs. Some businesses might seek to circumvent the regulation by moving their operations overseas where the regulatory framework is more relaxed.
The government has a key role and responsibility in correcting for market failure. It spends resources in making and enforcing laws that address such issues. Policies such as the grant of subsidies and direct provision of services impose additional costs on the government. On the other hand, the government can also earn revenues through taxation and the sale of tradable permits. These revenues can be used to further implement government policies in the light of it’s social and economic priorities.
The main purpose of the intervention in the case of externalities and common pool resources is to move society closer to the socially optimal level of output. Thus, the negative impact on third parties is reduced in the case of negative externalities and the positive impact from positive externalities is enhanced. Society, as a whole, benefits from this intervention because the misallocation of resources is corrected. Sometimes these effects can lead to long-lasting improvements in the environment as in the case of the shift to renewable energy motivated by the need to avoid carbon taxes and the cost of pollution permits.
However, there are unintended side-effects of all forms of intervention. Any form of intervention carries some misallocation costs: the price signal is distorted, the market no longer functions effectively and there are deadweight losses. The crucial factor is the extent to which the societal gains made by addressing the market failure exceed the misallocation costs resulting from intervention.
The impact of increased costs as a result of corrective action by the government on smaller businesses may prompt them to exit the industry. This reduces competition and may increase market failure on account of increased market power by the remaining (larger) firms. The relocation of firms to areas with less stringent regulation can increase unemployment. This may reduce societal well-being unless the government incentivises ‘greener’ industries and facilitates the shift of labour to those industries.
All forms of intervention in markets have side-effects and unintended consequences. Such intervention is justified when the overall gains made by society are larger than the allocative losses created. In other words, the increase in the welfare of the winners must exceed the losses experienced by the losers. A lot also depends on the manner in which the government might compensate the losers from the policy.