Author’s amended version of
image in Economics Online (2017)
imposition of a tax on, for example, polluting producers adds to their costs of
production so the MPC curve shifts upwards by the full amount of the tax. This
reduces quantity from QFM to QSO and raises price from P to P1. If the tax set
matches the value of the external cost it will remove welfare loss.
Another method of state
intervention would be to extend property rights in order to encourage Coasian
bargaining between agents. This can make the market more likely to reach a
Pareto efficient level by itself, decreasing the need for government
intervention in some cases and therefore reducing the risk of government
failure which may increase welfare loss.
A change in in legislation
is another method to reduce output. This was seen in the law introducing the 5p
charge on plastic bags for consumers from major retailers that reduced the
annual amount issued by 83% (The Guardian).
policies on their own have limits to the impact they can make on a market so
governments often combine several different methods to tackle the issue. An
example being that in the UK cigarettes are subjected to a high amount of
government intervention. They are heavily taxed and the areas in which smoking
is permitted has been reduced. State sponsored information campaigns have made
consumers aware of the dangers of smoking through tactics such as packaging
requirements and advertisements in media. The policies have been successful in
reducing consumption as a proportion of the population of a demerit good currently
the UK is experiencing its highest proportion of quitters since 1974 (ONS 2015).
So welfare loss is less than what it would be without intervention.
intervene in the market because the market fails to allocate resources
efficiently on its own. However, it is reasonable to mention that government
intervention can in some cases worsen resource allocation through factors such
imperfect knowledge making it difficult to value an externality.
summary, externalities exist as a market failure because they are failed to be
reflected in the price of the good that causes them. As a result there is no
market signal to agents to produce or consume at the socially optimum level of
output and so a welfare loss occurs, often in the form of over pollution or
deteriorated health for the public. This means the free market has failed and
is Pareto inefficient. If the characteristics of a market and its externalities
are right agents may use Coasian bargaining to correct the output and maximise
society’s welfare by minimising its loss and government intervention may aim to
extend property rights to encourage a self sufficient market. The state may
also want to intervene in a plethora of ways, using both direct policy and
economic instruments so the shortcomings of one policy are made up for by