Question

What kind of policies can be used to deal with negative externalities? For each policy explain the downsides.

Answer 1

Externalities commonly occur in situations where property rights over assets or resources have not been allocated, or are uncertain. For example, no one owns the oceans and they are not the private property of anyone, so ships may pollute the sea without fear of being taken to court.

Market-based solutions try to manipulate market forces to reduce the externality, by exploiting the price mechanism. One such market-based solution is to extend property rights so that third parties can negotiate with those individuals or organisations that cause the externality. British economist and Nobel Prize winner, Ronald Coase argued that the establishment of property rights would provide an efficient solution to the problem of externalities. As long as one party can establish a property right, there will be a bargaining process leading to an agreement in which externalities are taken into account.

We learn to live with externalities, or:

Government intervenes on our behalf through taxes or direct controls and regulations, such as:

Taxing polluters, such as carbon taxes, or taxes on plastic bags.

Subsidising households or firms to be non-polluters, such as giving grants for home insulation improvements.

Selling permits to pollute, which may become traded by the polluters.

Forcing polluters to pay compensation to those who suffer, such as making noise polluting airports pay for double-glazing.

Road pricing schemes, such as the Electronic Road Pricing (ERP) system in Singapore, which is a pay-as-you-go, card-based, road-pricing scheme.

Providing more information to consumers and producers, such as requiring that tickets to travel on polluting forms of transport, especially air travel, should contain information on how much CO2 pollution will be created from each journey.

The adoption of policies emerging from research by behavioural economists - often shortened to 'nudge' theory. This type of approach looks at influencing choices individuals make by nudging them towards more effective decison making.