Question

What would be the most efficient policy for the government to implement such that the cost of externality can be internalized in the market?

Answer 1

What forms of government intervention might help to correct the market failure from negative externalities?

To many economists interested in environmental problems the key is to internalise external costs and benefits to ensure that those who create the externalities include them when making decisions.

Pollution Taxes

One common approach to adjust for externalities is to tax those who create negative externalities.

This is known as "making the polluter pay".

Introducing a tax increases the private cost of consumption or production and ought to reduce demand and output for the good that is creating the externality.

Some economists argue that the revenue from pollution taxes should be 'ring-fenced' and allocated to projects that protect or enhance our environment.

For example, the money raised from a congestion charge on vehicles entering busy urban roads, might be allocated towards improving mass transport services; or the revenue from higher taxes on cigarettes might be used to fund better health care programmes.

Answer 2

The government can respond to externalities in two ways. The government can use command-and-control policies to regulate behavior directly. Alternatively, it can implement market-based policies such as taxes and subsidies to incentivize private decision makers to change their own behavior.

Command-and-control regulation can come in the form of government-imposed standards, targets, process requirements, or outright bans. Such measures make certain behaviors either required or forbidden with the goal of addressing the externality. For example, the government may make it illegal for a company to dump certain chemicals in a river. By doing so, the government hopes to protect the environment or other companies or individuals that use the river that would otherwise suffer a negative impact.