Download Environmentalists argue that motorists cause negative externalities

1. Environmentalists argue that motorists cause negative externalities.
Explain why negative externalities arising from increased car use are
an example of market failure.
(6 marks)
Negative externalities reduce society’s total utility and show market failure, as
social cost is above private cost. The market fails when society fails to
achieve allocative efficiency. Market failure can be caused by imperfect
competition; externalities; merit and demerit goods; information failure; factor
immobility; and uneven distribution of income.
The marginal private cost of using cars, such as the consumers’ cost of fuel,
is lower than the marginal social cost which consumers and producers tend to
ignore, such as congestion and pollution. This situation creates negative
externalities, as shown on the diagram below, which assumes that there are
no external benefits of motorists using cars.
Price
MSC (MPC + External cost)
MPC
P2
Negative externalities
P1
Actual market demand
Q1
Q2
Quantity
When making the utility maximising decision to use the car, motorists in
general will only take into account private costs, not social costs. Q1 quantity
of cars will be used for a private cost of P1, but will have a marginal social
cost of P2. The market is currently failing, as MSC is not equal to MPC and
therefore there are negative externalities of AB.
Negative externalities cause market failure when there is over consumption.
In this case, over consumption is caused by consumers who fail to consider
the social cost of driving. Allocative efficiency exists when society’s scarce
resources are allocated in such a way so as to insure that society’s total utility
will be maximised. As social cost exceeds private benefit, there is allocative
inefficiency as resources are misallocated.
2. Discuss whether using indirect taxation is an effective solution to the
market failure arising from negative externalities. (18 marks)
Indirect taxation is tax levied on goods and services rather than on the
individual. It is ultimately paid by the consumers in the form of higher prices.
This means it is a market based solution. An example of indirect tax is green
tax. The market fails when society fails to achieve allocative efficiency. Market
failure can be caused by imperfect competition; externalities; merit and
demerit goods; information failure; factor immobility; and uneven distribution
of income. Market failure is represented on the diagram below:
Price
MSC (MPC + External cost)
MPC
P2
Negative externalities
P1
Actual market demand
Q1
Q2
Quantity
Indirect tax is equal to the difference between the marginal private cost and
the marginal social cost, known as the negative externalities. For example, if
the private cost of driving a car is below the social cost of driving a car, the
motorist may have to pay indirect tax in the form of congestion charge,
therefore the polluter pays.
This polluter pays principle means that the indirect tax is equitable. Those that
pollute more will pay more in green tax, for example in the case of air travel
those that fly, and hence pollute, more will pay more in tax.
Furthermore, indirect taxes, such as green tax change producer behaviour as
polluters are forced into internalising their external costs. With the knowledge
that they will have to pay for their negative externalities by charging higher
prices and therefore potentially losing demand, producers tend to be more
inclined to adjust their behaviour in a way which benefits society, as they wish
to reduce their marginal social cost. This is because producers are profit
maximisers, and indirect taxes can reduce their profits. For example, a car
producer is more likely to invest in the development of environmentally
friendly technologies in order to reduce the impact the car has on the
environment, which would cause them to have to include high levels of green
tax in the prices of their cars.
In addition, indirect taxes change consumer behaviour, as consumers do not
like paying taxes. Owing to self interest, where possible, households will try to
change their behaviour in order to avoid paying large amounts of taxation. For
example, consumers travelling from London to Paris may change their
method of transport from plane to train in order to avoid high air passenger
duty. This would be an effective way of correcting market failure, as it would
reduce the marginal social cost of the consumers’ actions, therefore there
would be a shift on the market failure diagram of ASC to the right from MSC1
to MPC=MSC2, and the market would reach equilibrium of P1Q1.
Price
MSC1 (MPC + External cost)
MPC = MSC2
P2
Negative externalities
P1
Actual market demand
Q1
Q2
Quantity
However, indirect taxation may not always be effective. Indirect tax such as
green tax and congestion charges is regressive. This means that poorer
people have to pay a larger percentage of their income than the rich. This
could have little effect on the rich, who tend to use the polluting services such
as air travel, more. However, the same tax could dissuade a poorer individual
from travelling. Although climate change is everyone’s responsibility, the poor
could end up making sacrifices needed to save the planet, whilst the rich
don’t. This could increase the divide between living standards and the gap in
lifestyle.
Finally, placing money on externalities is difficult. It is hard for the government
to measure, for example, the cost to the NHS of the consumption of vodka,
therefore it would be hard for them to know how much the good should be
taxed. If economists working for the government over-estimate the value of
the negative externalities created, the duty imposed will be too high. As a
result, the market equilibrium output level will move too far to the left, beyond
the point MPC. Now there will be under-production. This is known as
government failure. Equally, if the government underestimates the effect cars
have on the environment, green taxes will be too low and there will still be
market failure, with over production of cars.
In conclusion, indirect taxation can be effective in correcting market failure,
however, it depends on the extent of which people want to consume the good.
If they want to consume it so much, for example for addictive products such
as cigarettes, they will be willing to pay whatever the price. Therefore the
indirect taxes will have no effect. Furthermore, time lags will occur as it will
take time for consumers to find substitute products and therefore indirect
taxation will not have an immediate effect on society. The effectiveness of
indirect taxation depends on ceteris paribus, as if the number of substitutes
does not remain the same, consumption of the good being taxed may change
for reasons other than indirect tax.
Lastly, in order for the taxes to be effective, the revenues generated should be
hypothecated. This involves the government setting aside the revenue
generated by a particular tax for a specific purpose, for example the London
congestion charge which pays for helping improve the quality of London’s
environment. However, no matter what the tax goes towards, the theory of
second best is relevant as at least it will have some effect on consumers and
producers.