Last updated: March 21, 2019
Topic: LawGovernment
Sample donated:

Climate change has become an issue of global discussion and it is the result of market failure. The effects of the increasing volume of carbon dioxide and greenhouse gases on the global temperature have become a major environmental issue throughout the world. Carbon emissions worldwide need to be reduced in order to avoid serious climate change. To encourage companies to invest in cleaner technology and reduce carbon emissions, the government has to attach a cost to carbon emissions.

There are a few approaches to limiting carbon emissions such as the cap-and-trade system and carbon tax (‘Good policy, and bad’ 2009). Government intervention can correct the distortions by market failure to improve economic efficiency. Hence, world leaders need to implement a carbon price in order to reduce the negative externalities which cause market failure. Market failure is the situation in which the market fails to produce the efficient level of output (Hubbard et al. 2009). The failure occurs due to the existence of negative externalities (in the case of the environment).

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Greenhouse gas emission and air pollution produced by power companies and manufacturers are examples of negative externalities. Negative externalities are the costs that affect someone who is not directly involved in the production of a good or a service (Hubbard et al. 2009). People with respiratory illness bear a cost even when they were not directly involved in the buying or selling of the electricity that caused the pollution. Externalities distort the economic efficiency of the market equilibrium.

There is a difference between private costs and social costs to society overall due to a negative externality. Private cost is the cost borne by the producer of a good or service while social cost is the private cost plus external cost resulting from production, such as the cost of pollution (Hubbard et al. 2009). Private cost and social cost will be equal in the absence of an externality. External costs of the air pollution caused by the burning of coal to generate electricity are borne by the public. Diagram 1 The graph above shows the effect of a negative externality.

The upward sloping line, S2, represents society’s supply curve or marginal cost curve while the upward sloping line, S1, represents the marginal cost curve that the firm with the negative externality faces. The negative externality results in an economically inefficient level of production, Q. Hence, there is a deadweight loss shown by the shaded area. Due to the cost of pollution, economic efficiency will improve if quantity produced is less. One measure that many economists suggest for placing a cost on pollution is the carbon tax.

Carbon taxes are priced-based policy instruments. The carbon tax is more vulnerable to capture by polluters (‘Stopping climate change’ 2009) and also provides incentives to reduce the negative externality, which in this case is pollution. As shown in Diagram 2, the government imposes a tax on production that is equal to the cost of pollution. As a result, power companies and manufacturers for example, will internalise the externality. Thus, the cost of pollution will be included in the private cost borne by firms, shifting the supply curve S1 upwards to S2.

New market equilibrium will be established due to a decrease in equilibrium output of electricity (Q1 to Q2). The price of electricity will then increase to P2, which reflects the cost of pollution. Diagram 2 Although governments earn revenue from carbon taxes, it is difficult to set the proper level of tax due to the difficulty of finding out the exact external costs. If the government sets the tax too high, then under-production will occur and vice versa if the tax set is too low. Futhermore, there is no limit on the amount of carbon that can be emitted.

Therefore, the target or desired quantity of carbon emissions may not be reached. The cap-and-trade system, on the other hand, is a market-based approach to reducing negative externalities, which is essentially the buying and selling of the ‘license to pollute’ by firms. For the cap-and-trade system, the government firstly decides on the acceptable amount of pollution that is allowed to be emitted. Firms are then issued permits based on their size and industry. Each permit allows a certain amount of pollution.

The supply of these permits is perfectly inelastic because the government decides the quantity. Firms that are unable to reduce their pollution below their cap are required to purchase more permits while firms that are able to lower the quantity of pollution below the cap can sell their permits, profiting while reducing their pollution. Hence, a market for these permits develops. As shown in Diagram 3, in the market for pollution permits, the cost of pollution will be determined by the demand among firms for the permits and supply of permits.

The government can decrease the supply of the permits if their prices are too low to make firms bear total social costs of their production. This will then increase the price and decrease the quantity of permits demanded, reducing the negative externalities of pollution as firms will shift to ‘greener’ technology for production. Diagram 3 The cap-and-trade system is relatively simple in operation. The demand and supply of the permits dictate the price, meaning that government intervention is not necessarily required. However, a cap-and-trade system entails significant transaction costs.

Transaction costs are the costs in time and other resources incurred in the process of agreeing to and carrying out an exchange of goods or service (Hubbard et al. 2009). The costs include search costs, negotiating costs, approval costs, and insurance costs. When dealing with a global issue such as climate change, getting an agreement is extremely difficult. When too many countries are included in a detailed negotiation, the chances of a successful agreement is slim (‘Getting warmer’ 2009). Thus, the cost of transacting exceeds the gain from the transaction.