Unit 2.

8(3): Government intervention to manage

externalities, merit and demerit goods
What you should know by the end of this chapter
Policies to deal with external costs and demerit goods:
• Tax
• Regulation
• Tradable permits
• Advertising
• Education
Policies to deal with external benefits and merit goods:
• Subsidies
• Regulation
• State provision
• Advertising
• Education

Reasons for government intervention

We know from the previous chapters that cover externalities along with merit and demerit good
that they lead to market failure. Without any government, intervention resources are misallocated
and the welfare of a country’s citizens is not maximised. Governments intervene when there is
market failure to affect resource allocation and improve the welfare of their country's citizens.
Governments do this by trying to move output in markets where there is market failure closer to the
socially efficient level where social costs equal social benefits.

Policies for external costs

The market failure associated with negative externalities leads to an over-allocation of resources and
a resulting welfare loss to society. The government policies associated with dealing with negative
externalities are based on the objective of trying to reduce the market output towards the socially
efficient level where marginal social costs equal marginal social benefits.

One of the central problems for any government trying to apply policies to reduce negative
externalities and achieve the socially efficient level of output is the problem of measuring external
costs and establishing where the socially efficient level of output is. For example, governments know
there are negative externalities associated with the consumption of alcohol but it is very difficult to
come up with an accurate measure of the extent to which resources are over-allocated in the
market. This measurement is further complicated by the existence of positive externalities
associated with the market for alcohol such as employment in related industries.

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Demerit goods
Many of the policies used to manage the market failure associated with consumption external costs
can be used to deal with similar market failures associated with demerit goods. The application of
indirect tax, regulation and demand-reducing policies can all be applied to demerit goods.

Taxation (Pigovian tax)

Tax on production external costs

Where an industry is associated with

significant negative externalities
governments can impose indirect taxes
on producers. An indirect tax adds to
business costs causing an increase in the
price of the good and leading to a fall in
output towards the socially efficient
level. This is illustrated by diagram 2.45,
where an energy company pays a
specific tax on the electricity it produces.

The tax is called 'Pigovian' because it was developed from the work of the UK economist, Arthur
Cecil Pigou who did significant amounts of research on market failure. In this example, the tax
increases the market price to P1 and moves output from Q to Q1 which is at the socially efficient
output at Q*. This removes the welfare loss associated with the electricity industry, although it
should be pointed out that in reality achieving the exact socially efficient output is impossible.

Tax on consumption external costs

Tax can also be imposed on negative

externalities of consumption. In many
countries governments tax cigarettes to
reduce their consumption and the
associated social costs. Diagram 2.46
illustrates the impact of an indirect tax
on cigarettes. The effect is similar to a
tax on good on negative externalities of
production, with the price of cigarettes
increasing to P1 and the output of
cigarettes being reduced from Q to Q* at
the socially efficient output. The tax
removes the yellow welfare loss triangle.

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Advantages of using tax:

• Tax revenue can be used to compensate affected third parties and to pay for the negative
consequences of an externality. For example, the tax revenue from cigarettes can be used to
pay for some of the healthcare costs of people who smoke.

• Increasing price is an effective way of reducing consumption and production.

Disadvantages of using tax:

• Tax can reduce the welfare of low-income groups where the price of a good is a significant
proportion of their income. For example, a tax on petrol can have a significant impact on the
incomes of poorer households who rely on their cars.

• Increasing business costs can lead to lower business profits and even business failure.
Increasing tax can be particularly significant for small businesses.

• If business costs rise in industries such as energy this could lead to a higher average price
level in the economy and increase inflation.

• The tax can make domestic firms uncompetitive on international markets and lead to a fall in
exports.

• If business output decreases because of the tax increase it can cause unemployment to rise
in an industry.

Regulation
Regulation of production external costs

The government can use legislation to regulate markets associated with

external costs. Governments can regulate production externalities by
requiring firms to meet certain criteria when they are producing goods and
services. For example, airlines flying into international airports are not
allowed to land and take off between 23.30 and 0600. The construction
industry is subject to government regulations when it is planning building
projects and needs to meet different planning regulations. There are
regulations on certain substances such as asbestos that cannot be used in
manufacturing processes.

Regulation of consumption external costs

The strictest form of regulation is to make the consumption and production of a good with
significant external costs illegal. This is the case with recreational drugs like cocaine and heroin
where consumption and production are illegal in most countries.

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It is also possible for governments to allow the consumption and production of a good but control
the market. Alcohol, for example, is a legal recreational drug but its consumption is controlled in
many countries in the form of age restrictions, licensing hours, licensed retailers, restricted
consumption in public places, restrictions on advertising and the products need to have health
warnings on their packaging.

Advantages of regulation:

• They can be targeted more specifically at a negative externality than taxation. If the main
pollutant in the production of a good is a specific chemical, then a regulation can deal more
specifically with that problem than a tax.

• Whilst regulations can cause an increase in costs, they are less likely to lead to an increased
price than a tax if the firm can comply with the regulation relatively easily.

Disadvantages of regulation:

• The cost of implementing legal restrictions can be significant for governments. For example,
governments spend huge amounts of money on their anti-drug law enforcement
programmes.

• Parallel markets arise in regulated markets and the goods provided can be in the hands of
criminal gangs. This is a particular problem in the recreational drugs market.

• Regulations can drive up business costs increasing prices for consumers. For example,
regulations on the burning of fossil fuels and CO2 emissions have increased the cost of
electricity.

• Firms can find their way around regulations.

• Businesses often locate production facilities in countries with lower regulations, which
adversely affects domestic employment and can move the externality problem to another
country.

Tradeable permits
The last 20 years have seen the rise in the market for tradeable
permits or cap and trade schemes, which are a market solution to
the problem of external costs. The market for CO2 emission
permits has become an increasingly important measure used to
control the negative externalities associated with C02 pollution as
a contributor to climate change.

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The system for carbon trading works in the following way:

• The government sets a total limit on the carbon emissions it will allow from an industry.

• The total of carbon emissions is then divided up amongst producers that emit carbon and
they are allocated a CO2 allowance.

• The producers are not allowed to emit more CO2 than their allowance.

• This gives producers in the industry an incentive to reduce their CO2 emissions because they
can sell any unused allowance they have to less carbon-efficient producers.

• If the government reduces the number of permits their price and value rise and there is a
greater incentive for producers to reduce their emissions.

To be truly successful in addressing climate change the carbon trading system needs to be an
international market and the emission limits need to be policed effectively. The current market for
CO2 permits is worth about $82 billion.

Advantages of tradeable permits:

• Carbon credits create an incentive system that is more effective at reducing CO2 than a tax
that firms need to pay whatever their carbon emissions.

• Using an incentive-based system facilitates innovation and firms develop technology to

reduce pollution.

Disadvantages of tradeable permits:

• The system is complicated and expensive to set up and administer.

• The number of permits allowed needs to be tightly controlled at an international level to

have any impact on CO2 emissions and some countries may not follow the system.

• The permits add to business costs and lead to higher prices.

Reducing demand
An alternative way of dealing with negative externalities is to reduce
the demand for the good associated with the negative externality to
the socially optimum level of output. This can be done through
government-financed advertising campaigns. Many countries run
advertising campaigns that try to persuade people to give up smoking
or taking recreational drugs. Similarly, governments run education
programmes that inform people of the hazards associated with
smoking, drinking alcohol and taking recreational drugs.

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It is also possible for governments to reduce the demand for goods associated with negative
externalities by subsidising products that are substitutes for the ones with the negative
externality. For example, subsidising public transport causes the demand for private car use to fall
along with the negative externalities associated with the use of cars.

Diagram 2.47 shows how an effective

advertising campaign against drinking
alcohol reduces its demand, which in
turn reduces the external cost associated
with its consumption. In this example,
the welfare loss is removed as D shifts to
D1.

Advantages of reducing demand

• Advertising does not add to business costs so the price of goods does not increase.

• For some consumption negative externalities such as cigarettes and alcohol, this approach
might be more effective as a long-term solution to the problem because it changes
consumer behaviour.

Disadvantages of regulation:

• There is an opportunity cost to the government of paying for advertising, education and
subsidies.

• The effectiveness of advertising and educational programmes are difficult to measure and
are sometimes questionable.

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Policies for external benefits
The market failure associated with positive externalities leads to an under-allocation of resources
and a resulting welfare loss because society misses out on the potential welfare gain from producing
at the socially efficient output. The government policies associated with dealing with positive
externalities are based on the aim of trying to increase the market output towards the socially
efficient level where marginal social costs equal marginal social benefits. One of the central
problems for any government trying to apply policies to increase output to achieve the socially
efficient level is measuring external benefits and establishing where the socially efficient level of
output is.

Merit goods
Government policies aim to encourage the consumption and production of merit goods. This is the
same set of policies discussed with positive externalities: subsidy, state provision, regulation,
advertising and education are applied to merit goods.

Subsidies
Subsidies on external benefits of consumption

When positive externalities exist in a market the government aims to increase market output to the
socially optimum level. The payment of a subsidy provides a financial incentive for producers to
increase output, and consumers to increase consumption of a good associated with positive
externalities. For example, governments subsidise anti-malarial drugs to make them more
affordable in developing countries.

Diagram 2.48 shows the impact of the

subsidy on anti-malarial drugs. Initially,
the market output is at Q below the
socially efficient level at Q*. There is a
potential welfare gain equal to the yellow
shaded area. When the subsidy is added
by the government the price falls from P
to P1 and output rises to the socially
efficient level at Q* and welfare is gained.

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Subsidies on production external benefits

By subsidising the production of a good

with positive externalities firms are
encouraged to increase output towards
the socially efficient level. Subsidies are
often paid to firms who locate in areas of
industrial decline because the positive
externalities of their location help to
stimulate regional economic growth.
Diagram 2.49 illustrates the effect of a
subsidy paid to businesses that locate in
an area that has suffered from significant
industrial decline. The price falls from P
to P1 and output increases to the socially
efficient output at Q*.

Advantages of subsidies:

• Subsidies create direct financial incentives that will increase output and capture the welfare
gain from external benefits.

• Low-income consumers benefit from lower-priced goods particularly if they are on necessity
goods such as healthcare products.

• Producers will be encouraged to increase output which creates employment.

Disadvantages of subsidies:

• There is an opportunity cost to the government of the subsidy in terms of other public
services they could have financed.

• The subsidy might take resources away from other products. A subsidy on, for example,
anti-malaria drugs may take resources away from drugs for other illnesses such as HIV

• Subsidies are often paid to high-income groups such as rich people benefiting from
subsidised healthcare.

• Subsidies can lead to a welfare loss where inefficient producers are drawn into the market.

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State provision
The government could choose to take the provision of merit goods and
other goods associated with significant positive externalities into the
public sector and provide the goods themselves at the socially efficient
level of output. This is particularly true in the healthcare and education
markets where the provision of these merit goods is seen as being so
important to society.

Advantages of state provision:

• Government provision of merit goods is the most direct way of increasing output towards
the socially efficient level.

• Many people believe the state is more likely than the private sector to make decisions about
the provision of merit goods that are in the public interest.

• Goods can be provided at the price (or zero price) that all households can afford. This is seen
as particularly important in healthcare and education.

Disadvantages of state provision:

• The cost of providing a state-run healthcare and education systems is extremely high and
carries a significant opportunity cost to the government

• Some people believe that state provision is less efficient than private-sector provision
because state-run organisations experience diseconomies of scale

• State-run organisations are often subject to considerable political interference which

compromises their benefits to society.

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Regulation
Governments believe that the consumption of some
goods is so crucial to the welfare of individuals in society
that the government forces people to consume
them. This is particularly the case with primary and
secondary school education where many countries make
it compulsory for parents to send their children to school
through the law.

This is also the case with car insurance where individuals legally need to own third-party car
insurance so people adversely affected by a car accident will be compensated.

Advantages of regulation:

• Laws compel individuals and businesses to make decisions that increase output to the
socially efficient level.

• Regulations can be targeted precisely at goods and services with positive externalities.

Disadvantages of regulations:

• There can be significant costs of policing the system and enforcing regulations.

• Regulations add to business costs which can reduce employment and increase prices.

• Some people avoid the regulations and parallel markets can develop.

Increasing demand
Governments can try to increase the
demand for goods associated with
positive externalities to move production
and consumption towards the socially
efficient level of output. For example, the
state can fund the advertising of things
like further education, healthy eating and
exercise to increase the demand for goods
and services in these markets and increase
the resulting external benefits.

Educational programmes can be used to increase the demand for merit goods by informing people
of the benefits, for example, of vaccinating against diseases like measles.

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Diagram 2.50 illustrates the impact of a government advertising campaign to increase the
consumption of fruit and vegetables as part of a healthy living policy. The demand curve for fruit and
vegetable shifts to the right and market output increases from Q to Q1 which is closer to the socially
efficient output Q*. As a result, some welfare is gained and is shown by the yellow area on the
diagram.

Advantages of increasing demand:

• Education and advertising are not as expensive as using subsidies and do not have the
management problems of regulation

• The approach can be effective in altering human behaviour which is an effective long-run
solution to the under-provision of goods associated with positive externalities.

Disadvantages of increasing demand

• The opportunity cost to the government of funding advertising and educational

programmes.

• It is not always easy to measure the effectiveness of advertising and educational

programmes.

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