What is Market Operation?
In the case of pollution, there cannot attain an efficient solution. So, for efficient solution government can intervene in several ways.
Creating a Market:
The inefficiencies associate with externalities can be linked to the absence of a market for the relevant resources. This suggests another way for the government to enhance efficiency, that is- sell producers permits to pollute. By doing so, the government in effect creates a market for clean air. Under this, the government authorities announce that they will sell the permits to spew Z* of pollutants into the environment.
The horizontal axis shows the rights for those industries who make pollution. The government announces it will auction off Z* pollution rights. In effect, the supply of pollution rights is perfectly vertical at Z*. The demand for pollution rights, Dz, that is downward sloping, the equilibrium price per unit is P1. Those firms are not willing to pay P1 for each unit of pollution they producers must either reduce their output or adopt a cleaner technology.
Imposing Pigovian Tax:
Those producers who are creating pollution, they produce their goods inefficient. Because the prices they provide for buying the inputs may incorrectly single social costs. A natural solution is to levy a tax on the polluter. A pigovian tax is a tax levied on each unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the efficient level of output (Saez Emmanuel, 2010).
- In this case, the marginal damage at the efficient output Q* is the distance (cd), that the vertical distance between MSC and MPC is MD. Before imposing a tax, polluter marginal cost was MPC for each level of output, after imposing tax the marginal cost of polluter is now MPC+cd. It means shifting up MPC by the vertical distance, which is shown by the distance (cd).
- Profit maximization requires for the producer where his marginal benefit (MB) equals to his Marginal cost. This now occurs at the intersection of MB and MPC+cd, which is at efficient output Q*. In effect, the tax forces producer to take into account the costs of the externality that he generates and induces for each of the (id) units produces. Hence, tax revenue is ( cd*id) which is equal to the area of a rectangle (iced).
- It would be tempting to use these revenues to compensate to those who still are being affected by pollution (Saez Emmanuel, 2010).
Because of negative externalities, the third party becomes worse off, here, the producer and the consumer are the first and second parties respectively, any organization, individuals or owner of any property can become the third parties. Negative externalities can also express as an external cost. Air is polluted from burning fossil fuels, emissions from burning gas, coal, and oil, water pollution, sound pollution are generally considered as the negative externalities. It creates many problems in the society. Their third party becomes worse off because of negative externalities. It also generates welfare loss in the society. The government in any society always tries to overcome and discourage negative externalities in the society and encourage or motive to generate positive externalities. A government imposes a tax in case of negative externalities and provides subsidies for motivating people to create positive externalities in the society.
Yale University, Economics