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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 byproducts 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.