Taxation most effective solution to market failure

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  • Created by: Matt Lowe
  • Created on: 09-04-13 13:02
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Discuss whether taxation is the most effective solution to the market failures arising
from negative externalities:
Market failure occurs when there is an inefficient allocation of resources in a free market. Negative
externalities are a spillover effect that negatively affects a third party: when social costs outweigh
private costs. Governments tend to intervene at these points in a variety of different ways, not
just taxation, including methods such as regulations and subsidies.
The negative externality here is pollution. A green tax on companies levied upon the volume of
pollution produced would potentially reduce pollution, as companies would invest more money
into greener methods of production; to avoid the taxation. However, it would still be difficult to
enforce and manage, as well as quantify the different types of pollution. Also, it could
prospectively slow economic growth as companies attempt to hurdle a green tax.
The diagram shows that a tax would reduce supply, causing prices to rise and the optimal
equilibrium would be lost. The point is though, despite a tax, companies would still pollute, not
solving the negative externality it set out to in the first place. So taxation isn't isn't the most
effective solution to the market failures arising from negative externalities.
There are other methods: subsidies promote innovative ideas such as utilising resources
effectively or harnessing renewable energy but realistically they aren't going to stop pollution
overnight. Permits that allow a volume/quantity to be polluted could be introduced. This would
mean companies could be fined for going over their allocated limit, however there would be
nothing stopping companies swapping permits in order to pollute as much as they needed to keep
production going. And at the end of the day, pollution is still happening, companies just now have
a certificate saying how much they're polluting. Regulations are a big decision to make; they would
effectively stop pollution but at what cost to the economy? And how would they be efficiently
enforced? Realistically, it's going to be very hard for the government to reduce pollution, but
externalities can be dealt with other ways: by internalising the externality the firm takes into
account the 'damage' the pollution might do, i.e. the extra cost of washing due to clothes tainted
with pollution. Non-monetary costs are no longer taken care of by the environment, but the

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The government would threaten companies to use cleaner technology or face being
shut down, forcing companies into investing in this technology and therefore internalising the
In conclusion, although taxation may be a very effective solution in theory, in practice it falls down.
There are various other solutions just as viable such as subsidising, and regulations. These are more
effective and could correct market failure, whilst reducing, if only slightly, the negative externality
of pollution.…read more


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