Discuss whether taxation is the most effective solution to market failures arising from negative externalities
Discuss whether taxation is the most effective solution to market failures arising from negative externalities
Market failure is when the free market fails to provide an efficient allocation of resources. Negative externalities are the costs to a third party of a particular action, and it is where the social cost is greater than the private cost.
Taxation is a solution to correct market failure which is arising from negative externalities. Introducing an indirect tax, (a tax levied on goods and services), can generate a reduction in consumption of the good which produce the negative externalities. An indirect tax can internalise the cost of the negative externality by discouraging its production. The government places a tax on producers, which will increase their costs of production. This can be shown in a diagram. The increase in costs of production will reduce supply and therefore shift the supply curve in from S to S1 which results in an increase in price from P to P1 and a decrease in quantity from Q to Q1. The tax is indicated on the graph as the difference between S and S1.
However, the effectiveness of this tax depends on the price elasticity of demand for the product. If the PED is inelastic, consumers will be unresponsive to a change in price, so producers may pass on most of the tax burden to consumers, who will continue to buy the product. The tax set by the government must be equal to the size of the external costs associated with the product, and this is difficult to set especially if the effect is not quantifiable. If the tax was set too low, it would be ineffective, and if it was set too high, the consumers may stop purchasing it altogether, which may have other undesirable outcomes. The amount of tax paid by the consumer is shown by area A, and the amount paid by producers is shown by area B. Ideally, producers should bear the full cost of the tax, but goods with inelastic demand may mean that they shift this on to consumers. Where consumers
Market failure is when the free market fails to provide an efficient allocation of resources. Negative externalities are the costs to a third party of a particular action, and it is where the social cost is greater than the private cost.
Taxation is a solution to correct market failure which is arising from negative externalities. Introducing an indirect tax, (a tax levied on goods and services), can generate a reduction in consumption of the good which produce the negative externalities. An indirect tax can internalise the cost of the negative externality by discouraging its production. The government places a tax on producers, which will increase their costs of production. This can be shown in a diagram. The increase in costs of production will reduce supply and therefore shift the supply curve in from S to S1 which results in an increase in price from P to P1 and a decrease in quantity from Q to Q1. The tax is indicated on the graph as the difference between S and S1.
However, the effectiveness of this tax depends on the price elasticity of demand for the product. If the PED is inelastic, consumers will be unresponsive to a change in price, so producers may pass on most of the tax burden to consumers, who will continue to buy the product. The tax set by the government must be equal to the size of the external costs associated with the product, and this is difficult to set especially if the effect is not quantifiable. If the tax was set too low, it would be ineffective, and if it was set too high, the consumers may stop purchasing it altogether, which may have other undesirable outcomes. The amount of tax paid by the consumer is shown by area A, and the amount paid by producers is shown by area B. Ideally, producers should bear the full cost of the tax, but goods with inelastic demand may mean that they shift this on to consumers. Where consumers