Public Policy: Using Market-Based Approaches - Department for ...

Existing market failures
If an existing market failure, in addition to the externality, exists, the use of a tax
may fail to maximise social welfare. For example, in an industry with a
monopoly supplier we would expect (everything else being equal) output to
already be lower than the socially optimal level. Where we have both a pollution
externality and monopoly power it will not be clear whether existing output is
above or below the socially optimal level. In the latter case a pollution tax would
reduce output further below the socially optimal level. In the presence of market
power it may therefore be appropriate to have a lower tax, or no tax at all.
Measuring emissions
Where a tax is used to control pollution it will be necessary to accurately
measure emissions. Where measurement is not feasible it may be possible to
use a proxy measure, such as an input associated with the relevant pollutant –
coal could be used as a proxy for SO 2 emissions, for example. The use of such
proxies can reduce measurement and enforcement costs, but can also reduce
the efficiency of the tax. The tax might fail to provide incentives to use
technologies which reduces the level of emissions per unit of input, for example.
The appropriate tax rate
Calculating an appropriate tax rate would in theory require accurate information
on the marginal cost to society of the externality that is taxed. In practice this
information is unlikely to be known, which may suggest that a marketablepermit
system might be more appropriate. Where a tax is used it will be
necessary to adjust its level form time to time to reflect the effects of inflation
and economic growth – a process which occurs automatically through changes
in market prices under a marketable-permit scheme.
Subsidies
Subsidies raise many of the same issues as taxes. In addition, where a subsidy
is used to reward reductions in a negative externality by increasing the quantity
consumed of a substitute good (reductions in pollution, for example) there is a
risk that the subsidy will encourage new entry into the industry, thereby
increasing the overall level of the externality. For this reason, a tax is likely to be
more effective at reducing a negative externality.
CONCLUSION
Section 7 – Market-Based Mechanisms
Taxes and subsidies can be a more efficient means of achieving a desired level
of externality than direct regulation. They may be preferable to a marketable
permit scheme where uncertainty surrounding the cost of externality reduction
means that setting the wrong quantity of permits could have significant and
undesirable economic impacts. However, they can also drive the economy
further from the socially optimal outcome when other market failures are
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