Correction of market failure

There are various measures a government could undertake to correct market failure: for example, indirect taxation, subsidies, tradable pollution permits, the extension of property rights, regulation, buffer stocks and minimum prices. The relative merits of each measure are now considered in relation to different types of market failure.

Indirect taxation

Indirect taxes are taxes levied on the expenditure of goods or services.  The government often imposes taxes on goods which have significant external costs, such as petrol, alcohol and tobacco.

The following diagram shows the market for petrol, including both the marginal private cost curve (MPC) and the marginal social cost curve (MSC). In a free market the equilibrium price is OPe and the equilibrium quantity is OQe. However, the socially optimal price is OP1 and the socially optimal quantity is OQ1, where marginal social cost equals marginal social benefit for the last unit produced. THe vertical distance ZY represents the external cost (air pollution) for each litre of petrol consumed.

By placing a tax equal to the external cost of ZY per litre, the government successfully internalises the pollution. The total tax collected is shown by the area P1YZW. Both producers and consumers pay the tax depending on the relative elasticites of demand and supply. The consumer tax area is YP1PeT and the producer tax area is PeTZW.

[diagram on page 48]

Advantages of indirect taxes to correct market failure

  • Indirect taxes are based on the principle the the polluters pay: both the consumer and the producer.
  • Indirect taxes work with market forces, helping to internalise the external costs while maintaining consumer choice.
  • The level of pollution should fall as output of the good or service is reduced and the price increased. The socially optimal level of MSB = MSB can be achieved.
  • Tax funds are raised for the government and these can be used to clean up the environment or to compensate the victims of pollution.

Disadvantages of indirect taxes to correct market failure

  • It is difficult to quantify the pollution and then place a monitary value upon it. Consequently, the socially optimal level is hard to achieve.
  • Indirect taxed increase the costs of production for firms, making them less competitive, compared to forms in other countries where such taxes are not applied. Therefore firms may relocate.
  • The demand for the good or service may be price inelastic and so the overall reduction in pollution levels may be small.
  • The tax revenue raised may not be used to compensate victims or clean up the environment.
  • It might encourage the development of illegal markets: for example, tobacco and alcohol smuggling to avoid high taxes.


A subsidy is a grant provided by the government to encourage the production of a good or service. Subsidies are often applied on goods or services with significant external benefits, such as education and healthcare. They may also be given to alternative forms of economic activity  which create less pollution, such as public transport or renewable energy.

Diagram (a) below shows the application of a unit subsidy to the market for electricity from renewable energy sources. The effect of a subsidy is to lower the price of each kilowatt of energy from Pe to P1 and increase the quantity from Qe to Q1.

The subsidy per unti is AB and the total subsidy area is ABCP1. Part of the subsidy is passed onto consumers in the form of lower priced energy, equal to the area AGPeP1. The other portion of the subsidy GBCPe remains with the producer. The lower price of electricity from renewable energy sources will help decrease the demand for energy from non-renewable sources from D to D1 (diagram (b)).

[diagram on page 49]

Advantages of subsidies applied to renewable energy markets

  • They reduce air pollution
  • Using renewable energy sources helps to promote sustained economic growth
  • The rate of consumption of non-renewable energy sources is reduced.
  • Subsidies work with the market. They help to internalise the external benefits from renewable sources of energy.

Diadvantages of subsidies applied to renewable energy markets

  • There is an opportunity cost to government subsidies. It may lead to higher taxes or cuts in government spending elsewhere.
  • Firms may become inefficient in production if they rely on subsidies
  • Wind power may be a less reliable source of energy than traditional fossil fuels

Tradable pollution permits

In 2005 the European Commission set up an emissions trading system (ETS) in an attempt to limit greenhouse gases from heavy industry. Its main focus is to curb carbon dioxide emissions by major polluters in the EU, such as power generators, steel, paper, cement, and ceramics industries. It is intended to include the aviation industry by 2012.

The ETS is a ‘cap and trade’ system. Each year, the EC allocates a set amount of carbon dioxide permits to national governments,  which then divide up the allowances among the firms covered by the scheme. This ‘caps’ the amount of carbon emissions for the year. The pollution permits are tradable, which means firms can buy and sell the allowances between themselves.

Most of the permits have been given free to industry and allocated on the basis of the amount of pollution generated before the scheme was created. However, national governments are able to retain 10% of the permits and offer them for sale depending on the level of scarcity. THe ETS gives an incentive to firms to invest in green technology and so reduce carbon emissions in the long term.

The ETS allows firms to invest in schemes that reduce carbon dioxide emissions outside the EU: for example, in India and China. The savings in carbon emissions can then be offset against their own emissions in the EU.

Advantages of tradable pollution permits

  • A market is created for buying and selling carbon permits, just like other goods and services. In effect, the price mechanism is used to internalise the external costs associated with carbon emissions
  • Pollution permits can be reduced over time as part of a coordinated plan. FOr example in 2008 the EC cut the allocations by 5%.
  • National governments can raise funds by selling their 10% of the pollution permits to the industry. The revenue could then be used to clean up the environment or compensate victims.
  • Forms have an incentive to invest in clean technology.
  • Production costs will increase for forms that exceed their pollution allowances, since they have to purchase additional permits and this provides a source of revenue to cleaner firms that can sell their exces pollution permits.
  • The ETS may act as a foundation for a global scheme. It has attracted interest from developed countries outside of the EU. The US state of California  intends to join the scheme.
  • Firms may be able to bank their excess pollution permits for future years.

Disadvantages of tradable pollution permits

  • The EC may allocate too few carbon permits so that production costs for EU firms increase rapidly, reducing their international competitiveness. Some firms may even relocate outside of the EU to reduce production costs.
  • Disputes have arisen over the allocation of carbon permits to forms. Some companies believe they should receive larger allowances and have taken legal action against the EC.
  • Firms may pass the cost of purchasing pollution permits onto the customer leading to higher prices of essential goods. This is more likely to happen if demand is inelastic.
  • There is less pressure on major polluting forms to clean up their act if it is easy to buy permits from elsewhere.
  • The price of pollution has fluctuated considerably since the schemes inception in 2005. For example, the price of carbon emissions varied from €25 to less than €1 per tonne. This has created uncertainty among firms about wether to invest heavily in carbon reducing technology.
  • Pollution permits may create an entry barrier for new firms to enter the industry, so restricting competition
  • There is a cost to the government of monitoring pollution emissions
  • Not worldwide – China and the US still polluting

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