Corrective Policy and Negative Externalities

This article throws light upon the top three policies taken by government that will correct negative externalities. The policies are: 1. Taxation 2. Subsides 3. Regulation.

Type # 1. Taxation:

Corrective taxation of negative externality, forces market participants to account for the opportunity costs of all resources allocated in private market.


Consider the case of a rubber processing industry in a competitive market. The bye product of production is emission of a rotten smell that fouls the air for 200 households in and around the factory.

No property rights are issued for the air space, and therefore neither the rubber manufacturer nor the households may charge the other for use of scarce air space. The rubber manufacturer who use free air may produce at point T1 and charge a per unit price of P1 because at this point MPC = MSB.

This is an efficient output level from the point of view of rubber manufacturer. However socially effi­cient production of rubber is determined, where MSC=MSB. This occurs at point T2, will a higher per unit price of P2.

Taxation and Externality

According to Prof. A.C. Pigou negative externality can be overcome and socially efficient level of output can be achieved by way of improving taxes on producing units, By imposing a tax equal to the level of the externality generated (MSC-MPC) public policy forces manufactures to fully account for all resources used in pro­duction.

When externality is added to producer’s costs, manufac­tures base their production decisions on marginal social cost.


In effect tax imposition replaces MPC with the higher MSC. After the imposition of tax, the rubber manufactures produces T2 output, at a price per unit of P2. At this point resources are efficiently allocated.

Type # 2. Subsides:

Another method is provision of subsidies. Subsidies result from poli­cies that pay firm for not producing negative externalities.

In our example of rubber processing industry, firm could be awarded prop­erty right for air space they use, and payment for cleaner air comes from taxpayers who pay the subsidies provided by the policy. The impact of the policy of subsidy can be illustrated with the following diagram.

Subsidy and Externality

Figure No 2.4 shows the relevant cost benefit curves for rubber product market. Before the subsidy programme, the firm produces T1 quantity of the commodity, where MPC: MSB. In-order to lower production to the socially efficient level of T2 a subsidy must be offered.


This set the firms marginal opportunity costs equal to mar­ginal social benefits at T2. Subsidy becomes an additional opportu­nity cost since for each unit they decide to produce, they give up a subsidy.

For example if the subsidy is equal to Rs. 21- per quintal, then reduction of production from 10000 quintal to 9000 quintal yields a subsidy payment of Rs. 2000. This will force the rubber product manufacturer to base production decision on MSC and not on MPC.

A subsidy equal to the difference between MPC and MSC creates incentives for firms to internalize negative externality in this market. For example at T1 level of output, a per unit subsidy of e.g., raises marginal opportunity costs to Ob.


Since marginal opportunity costs exceed marginal benefits of Qa, firms increases profit by cutting back production to the point where marginal opportunity cost are equal to marginal benefits. This equality is attained at point T2 which is the socially efficient level of production. A firm lower production to socially efficient levels and receives subsidies equal to dcfh.

Type # 3. Regulation:

Regulation is another means by which government attempts to deal with negative externalities. It is called as command and control policy.

Government regulation commands various firms and individuals to control behavior that creates negative externalities. Regulation is very different from tax and subsidy policies. Regulation sets in mini­mum environmental quality levels or maximum allowable levels of externalities.

For e.g., rules and regulations of civic authorities re­garding garbage disposal and recycling. Regulation also requires enforcement. The ability to enforce standards depends upon resources of the enforcement agency.

The government may enforce economic legislation to prevent externalities effect. For example smoking may be prohibited in public transport, there may be one way entry to avoid congestion in a street, and cutting of trees in public places may be prohibited and so on.

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