Sometimes market activities (production, buying, and selling) have unintended po

Question

Sometimes market activities (production, buying, and selling) have unintended positive or negative effects outside the market's scope. These are called externalities. As a policy maker concerned with correcting the effects of gases and particulates emitted by and local power plant, answer the following questions:

1. What two policies could you use to reduce the total amount of emissions?
2. Why do you think they each would work?
3. What would the benefits of each action be (besides emissions reduction)?
4. What would the costs of each action be?
5. How would you decide what was the best level of emission reduction?

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Unit Materials

Explanation / Answer

1. Two policies that could be used are a) A Pigouvian tax (A tax used to reduce output to the socially optimal level) or b) A Cap and Trade System (firms have their output of pollution limited, and then can trade or sell the right to pollute) 2. Both a Pigouvian tax and a cap and trade system would make polluting more costly, and therefore the firm would internalize (at least partly) their externality. Therefore, they would pollute less. 3. The benefit to a Pigouvian tax is that it is exact. It the tax would be equal to the externality. The benefit of a Cap and Trade system is that it utilizes a market, which ideally will self-correct,leading to the socially optimal output. 4. A Pigouvian tax can be difficult to implement because one much know the cost structure of a firm, which can change over time. So, the tax may also need to be adjusted over time. Cap and Trade can be problematic in that it may give more rights to certain pollution producers than others, as it is typically based on a history of pollution. It will not necessarily correct the externality completely. 5. The level of emission reduction with a Pigouvian tax is exactly equal to the externality. In a Cap and Trade system, firms determine an efficient level of pollution collectively through the trading of the right to pollute.

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