Section+Two+Questions-+ItzelC

__ 4. Pollution is sometimes said to be an example of market failure. What is meant by this? How might governments encourage markets to work towards helping solve environ­mental problems? __ Market Failure occurs when a given market fails to allocate resources efficiently and resources are over or under allocated for the production of a certain good or service. Pollution is said to be an example of market failure because it can occur due to the over allocation of resources to the production of various goods and services. This is originated as a result of an individual’s (or a firm’s) pursuit of self interest as firms would want to produce more of the product providing them with the highest profits, even when this brings about negative externalities such as pollution. Another reason for market failure might be that the cost-benefit analysis, which aims to evaluate accurately the costs against the benefits of producing something is carried out only taking into consideration private benefits and costs without due regard to public goods and social costs. Therefore, market failure occurs when a firm’s decision to produce a certain good is taken regardless of the social costs that this will entail for society at large.

In order to solve a market failure and correct the inefficient over allocation of resources to the production of a certain good or service causing pollution, and with the aim of encouraging markets to work towards solving environmental problems, the government might choose to allocate a value to the social costs or public goods affected by means of imposing Pigovian taxes per unit of the good or service causing pollution or to devise a scheme of tradable pollution permits.

By setting a Pigovian tax the government aims to set the price of each unit of pollution. Pigovian taxes would therefore make it more expensive for firms to produce that specific good or service causing pollution and would therefore discourage them from producing more. Pigovian taxes might also affect the demand for that good or service as the price might increase. The price might only increase if the demand for that specific good or service is inelastic and not very likely to be affected by change in price, however this might be different if the demand is elastic as the producers would therefore be forced to absorb all or most of the tax. The graph shows how a pigovian tax sets the price of polution.

By using tradable pollution permits the government aims to control the quantity of pollution permitted. It provides businesses with licenses from the government that set the overall market pollution to a point and where it is at its optimum level. Therefore, tradable permits create a market that incentive the use of more sustainable production methods as it is on the business’ best interest to minimize their production of pollution. This is because if they produce more pollution than they are allowed to by their permits they would have to purchase more permits from other companies which would increase their production costs, however if they pollute less than they are allowed to by their permits they would be able to sell their permits to other companies. This graph shows how tradable permits set the quantity of PolutionThis graph shows how as quantity supplied is fixed, an increase in demand would only cause the value/price of each permit to go up.

http://ib-econ.wikispaces.com/Section+Two+Questions+%28Microeconomics%29 Link to the original question in Section 2.