Economics "Ask the Instructor" Clip 19 Transcript
How does government affect the economy?
The government can impact the economy is several ways. Here we will focus on only one of the many activities of government: the role that government plays in dealing with externalities. The term externalities, sometimes-called spillovers, refers to the effects of any economic activity that spills over to affect third parties, meaning a party that is not the buyer or the seller in a market exchange. The spillovers can be either positive or negative. Pollution is an example of a negative externality. A key feature of an externality is that the person or business that causes the externality does not compensate those harmed (nor might they receive compensation in the case of a positive externality). The market ignores in other words, the side effects, whether they’re good or bad.
Take the case of pollution. The firm producing a product considers only those costs that it must bear. The firm takes labor and material costs into account because it must pay these costs. However, what if a firm dumps industrial waste into the air or nearby river. Dirty air and water are obviously costs from to society. Other uses of the air and water are given up. However, they are not costs to the polluting firm because the firm is not required to pay for the right to pollute the river or air. Why not? Because no particular person or group owns the river or the air. You have the right to ban pollution from your property, say, your yard, but the air and the river are owned by society in common. Therefore, no person can exercise ownership rights over the air, lakes, and rivers.
This makes for a conflict between what is best for the owners of the firm and what’s best for society. The owners of the firm, we assume, wish to maximize profit. And getting rid of industrial by-products as cheaply as possible furthers this objective. Thus, pollution occurs. On the other hand, society values clean air and water.
What action can government take to get the firm to reduce pollution? One action is to enact and enforce regulations requiring a reduction in pollution. The firm could be forced to find an alternative way to get rid of its by-products or could be required to install equipment that reduces emissions. The effect will be to increase the firm’s costs of production, consumers will pay a somewhat higher price, and less of the good will be provided.
A second course of action is for government to levy a pollution tax. This will have the effect of increasing production costs, too, because now the firm must pay a tax on the waste that it produces. You have already learned that a tax levied on the producer shifts the supply curve to the left. So you should not be surprised that the price rises and output falls.
Finally, government could create an arbitrary number of “pollution rights” and require that a firm purchase rights to pollute as a prerequisite for continued production. For this to be effective, some government agency such as the Environmental Protection Agency must be able to monitor pollution levels. This, too, will have the effect of reducing supply and increasing price.
None of these policies is likely to be popular with owners, and may not be with employees or consumers, because each is likely to reduce profits, reduce employment, and result in higher prices for consumers. However, it is important that the “real”, or full, cost of production (financial costs to the firm as well as damage done to the environment) be taken into account when allocating scarce resources.
And without government action it is very unlikely that persons being negatively affected by externalities will be successful in obtaining compensation for the damages that they experience. And if the perpetrator of the negative externality (in our example the firm) does not “internalize” these side effects, production will be greater than optimal and a misallocation of resources will occur.