To what extent might the problems of negative externalities be resolved by the use of indirect taxation? [15 marks]

Define Market Failure

Market failure is the inability of market forces of demand and supply to achieve allocative inefficiency, ie welfare not maximised (DWL exists) and there is requirement of government intervention. Welfare is maximised or market is efficient only if MSB=MSC at socially optimal output.

Define negative externalities

Costs incurred to third parties who are not directly involved in production and consumption of goods and services. It negatively influences third bystander who is not involved in transaction. Without government regulation, the price mechanism does not internalise the external cost generated (for example, if a person smokes and creates 2nd hand smoke or health problems to the person beside him, he does not pay for it).


When MSC > MPC (because MSC=MPC+MEC), for example, in the production of factories,

– MPC: factories cost of rent and wages
– EC: air pollution from carbon emission
– MSC: factories cost of rent and wages +  air pollution from carbon emission

Society incurs the private costs of production + water/air pollution generated, which is not internalised to private costs (the costs of running the factories.

From diagram, social welfare is maximised when MSC=MSB, at Qopt. This is where each incremental benefit= each incremental cost. But in the absence of government regulation, external costs are not internalised by price mechanism, society consumes at MPB=MPC, or output Qm.

This results in over-consumption and welfare loss (or dwl), which it the shaded region in the diagram.

OR, Consumption

When MPB > MSB  (because MPB=MSB+MEC), for example, in the consumption of cigarettes, private individuals enjoy greater benefits from smoking as opposed to society, who incurs external costs of air pollution and health problems to non-smokers, as a result, MSB<MPB.

From diagram, social welfare is maximised when MSC=MSB, at Qopt. But in the absence of government regulation, external costs are not internalised by price mechanism, society consumes at MPB=MPC, or output Qm, this means they do not pay for the external costs generated, such as a smoker does not pay the costs required to clear up the second smoke and air pollution.

This results in over-consumption and welfare loss (or dwl), which it the shaded region in the diagram.

Negative Externality Diagram

Negative Externality Diagram

From Diagram, Social welfare is maximised when MSB = MSC, at Qe, but in the absence of government intervention, private market consumes at Q1, where MPB=MPC, resulting in over-consumption and welfare loss in the shaded region.

Market failure exists because the price mechanism fails to internalise the external costs to producers and consumers, resulting in over-allocation and welfare loss of such items.

Cost and benefit diagram

Cost and benefit diagram


Governments can use a variety of measures, amongst which, indirect taxation. Indirect taxation is a form of tax that  levied on producers, who then pass on the tax to consumers in terms of higher prices. An example would be carbon taxation on factories for negative production or excise tax for cigarettes and alcohol (negative consumption).

This solves market failure as it internalises the external costs of  production and consumption, forcing private individuals to pay for externalities(external costs) generated. The allocation of such resources will then be reduced, and if all of the external costs are indeed internalised, then MEC=0. With reference to diagram, a tax shifts MPC to the left, allocation now is reduced to Q1, where MPB=new MPC(tax). As a result, allocative efficiency is achieved, there is no deadweight loss, and welfare is maximised.

For consumption, with a tax, MPC or supply shifts leftward due to rise in costs, output drops to Q1, where MPB=MSc, allocative efficiency achieved, welfare loss eliminated.

Taxation has its limitations because it is not possible for governments to quantify the external costs, it is at best an approximate and markets might not actually be consuming at Qopt if calculation of external costs was inaccurate.

A tax might also be ineffective in eliminating the external costs directly. For instance, taxing consumers for the use of motor vehicles does not eliminate the air pollution created. It is only effective if governments use the revenue to subsidise clean energy or green vehicles.

If demand is inelastic, taxation would be ineffective, because qty dd is unresponsive to price change. A huge amount of tax would have to be levied (which might lead to inequity distribution since only high income earners can consume such products), and possible growth of black markets.

Quota/tradable limit/carbon trading scheme

Government can use a quota/carbon trading/permit to limit the quantity of certain goods or services produced in a country. An example of quota would be carbon trading schemes in the case of negative productions. A Quota is a restriction on output as determined by governments. By setting the quota at the level of social optimal output, or Q* from diagram, the markets will be forced to consume at the social optimal output and achieve allocative efficiency. The supply therefore is perfectly price inelastic and output does not respond to price change. It is effective because the maximum that allocation is not fixed to Qs, and cannot go beyond that.

The limitation of a quota is it leads to extremely high price fluctuations for given change in demand. This might lead to equity problems especially in the consumption of fuel, since fuel is a basic economic necessity, and in some countries, even require subsidies.

Legislation + Education

Negative advertising and education/legislation could be implemented. Providing information on external costs and negative information would reduce the demand over time, and lead to a reduction in consumption. For example, governments could tell people about the harms of smoking and alcohol related problems.

Legislation such as restriction of underage consumption of alcohol, cigarettes, would completely eliminate external costs such as health problems to bystanders, or reduced crime rates from alcoholism. Over the long run, there is reduced demand, MPB shifts down to Qopt in negative consumption diagram.

The limitation of such policies are that they are long run in nature, especially for education.

It also requires governments spending intensively, which incurs opportunity costs, since such spending could be better used in other areas such as subsidising health care, education, etc.

In short, each policies have their limitations. Demand side policies like tax should be used in short run to control the consumption of items such as cigarettes, alcohol, fuel. Quota might be better in controlling the production, in cases such as carbon trading, where firms have ability to pass on the tax to consumers. In the long run, a good mix of short run demand policies and education could be used to control consumption and force markets to internalise external costs to achieve allocative efficiency.

See Schedules and Rates ; Economics
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