(b) Evaluate the idea that a government should use tradable permits to correct the market failure resulting from the existence of a negative externality. [15]

(b) Evaluate the idea that a government, for instance Singapore’s government, should use tradable permits to correct the market failure resulting from the existence of a negative externality. [15]

Adapted from an actual Economics Examination: November 2008, H1, A-Level

This paper discusses whether a government such as that of Singapore should use a policy of tradable permits to try to correct market failure resulting from the existence of a negative externality. An externality is a third-party spill-over effect affecting the welfare of a third-party in production/consumption of a good, but he neither receives nor pays compensation for that effect. In pursuit of their self-interest, producers and consumers only consider their own private costs and benefits and not account for their third-party effects, hence creating a divergence between private and social costs and benefits. However this paper discusses only negative externalities in production. One example of a negative externality in production is pollution.

Under the assumptions of perfect competition, the Marginal Private Cost curve is the same as the Marginal Social Cost Curve and that the quantity of pollution rises with output; the demand-supply diagram of a negative externality in production reflects this situation.

Diagram.

The free market equilibrium is at Em with output Qe units, since firms equate their MPC to price (MPC=P). Since the production of the good generates negative externalities, otherwise known as Marginal External Cost (MEC), the Marginal Social Costs arising from individual’s consumption of the good (MSB) is higher than Marginal Private Cost (MPC) by amount of the MEC, creating a divergence between MSC and MPC. However, the socially desired output level is Qs units (where MSB=MSC).  From society’s point of view, there is over-consumption of the good by QsQe units, and too many resources are channelled to its production. This is a situation of allocative inefficiency. The money value of benefits from output QsQe =Area QsEsRQe, and the money value of resources from output QsQe =Area QsEsEmQe. Hence the deadweight loss in not producing output QsQe = Area EsREm, showing that there is a market failure.

To correct a negative externality in production, a government such as Singapore’s can help adopt a policy such as using tradable permits. In the case of pollution, the government can use tradable carbon permits. A tradable permit is a government set quota to limit the production of a good that is a negative externality, hence limiting the amount of production of negative externalities by firms. Based on a cap and trade principle, the firms purchase permits to pay for every unit of negative externality they generate, and the cap set by the government is the socially optimal level of production of the good associated. At the same time, firms who find it more incentivising and cheaper to internalise the externality than holding on to the permits, via means such as research and technological development, will do so. This causes the external costs to society, and hence the divergence between the MSC and MPB to fall, as these producers now internalize these externalities. At the same time, they sell their permits to other firms who do not have the ability or willpower to do so. Society as a whole hence produces less of this good, and the market produces the socially optimal output of the good generating negative externalities. Hence the market failure is successfully and fully corrected. Even though the government intervenes, this market based solution does not require excessive monitoring freeing up the government’s resources for other uses. More importantly, it allows the market to use the most efficient and efficient means to abate the amount of good produced, internalising the externalities.

However, using the tradable permits scheme has its disadvantages as well. On one hand, geographical areas which have the presence of firms that can internalise the negative externalities reduce the external costs to third parties. However, this increases or concentrates the externalities in other geographical areas where firms which do not find it cheap to internalise them but produce more via purchasing more permits. This is counter-intuitive to the aims of the policy, which is to reduce or eliminate the negative externality. Even though society as whole reduces the externality, there is merely a redistribution of the externalities between those who can and cannot afford to reduce it, which could be inequitable.

At the same time, the government can introduce an indirect (Pigouvian) tax on producers to reduce the negative externality, equal to the marginal external costs to third-parties. This is shown in the diagram below.

Diagram.

Using this tax causes the producers and consumers to internalise the costs as well, because it is a market-based solution. Such a tax allows markets to continue operating along market forces to a large extent. Although prices have been inflated by taxes, consumption and production decisions are made while firms and household pursue their own self-interest. Apart from taxes providing revenue for governments to finance social and community development projects, most importantly, society as a whole reduces the externality by internalising its costs without concentrating it or reducing it only in specific geographical areas, unlike tradable permits.

Conclusions

In conclusion, governments like the Singapore government can not only use tradable permits, but also other policies such as taxation to reduce negative externalities. This is because each of these policies has their distinct advantages and disadvantages. Despite its disadvantages, I believe that governments should employ the tradable permits scheme. In a technologically-advanced country like Singapore, a majority of firms can readily seek solutions to internalise the externality, since they have the advantage of technology and financial power. At the same time, taxes might not be so effective, especially if the demand for that good or service is price inelastic. This is because a very high tax has to be imposed before any effect on production or consumption can be achieved. This also reduces the government’s popularity, as people view the government as trying to gain from the people, what more if a high tax is imposed. Despite being effective, the government’s vote pool might be reduced, which is not what it wants –maximise votes from the people. Hence, a regime of tradable permits is more effective to implement in countries like Singapore.

JC Economics Essays: Tutor's Comments - This is the second part to an Economics answer based on an actual "A" level Economics examination, but amended to fit this post to demonstrate the answering technique and approach. This Economics essay is about tradeable permits, a very hot topic - and one major suggestion that I would give is that students should find out about Ronald Coase, and his paper on Social Cost (where he came up with what is eponymously known today as Coase Theorem or Coase's Theorem). By the way, whilst Coase might seem to have nothing to do with this paper in the eyes of some new Economics students, because they might not have taught this in schools, the inclusion of his ideas into this paper would be a very good idea because Coase's ideas fit into this whole approach of tradeable permits, with the ideas of transaction costs, trading and bargaining, and internalisation of externalities. In fact, it can be argued that tradeable permits are an application of Coase's ideas. Those are relevant Economics materials that can be included into this paper. Having said that, this is a well written answer that is to the point and analyses the diagrams (they were drawn in the actual answer); yet, my usual tutor's question applies: how would you improve this Economics answer? Thanks for reading and cheers.