The government can respond to externalities through command-and-control policies or market-based policies.
Skills to Develop
Describe the role of government regulation in addressing externalities
The government can respond to externalities in two ways. The government can use command-and-control policies to regulate behavior directly. Alternatively, it can implement market-based policies such as taxes and subsidies to incentivize private decision makers to change their own behavior.
Command-and-control regulation can come in the form of government-imposed standards, targets, process requirements, or outright bans. Such measures make certain behaviors either required or forbidden with the goal of addressing the externality. For example, the government may make it illegal for a company to dump certain chemicals in a river. By doing so, the government hopes to protect the environment or other companies or individuals that use the river that would otherwise suffer a negative impact.
No Smoking: The prohibition of smoking in certain areas is a regulation designed to reduce the negative externalities suffered by non-smokers when they are around smokers.
In practice, implementing regulation effectively is difficult. It requires the regulator to have in-depth knowledge of a certain industry or sphere of economic activity. If done incorrectly, regulation can introduce inefficiency. For example, if the government makes it illegal to dump in the river, the companies and their customers may suffer because the products must be produced using less efficient methods. On the other hand, if the government allows too much to be dumped in the river, they have failed to mitigate the negative externality.
If the government is unsure of how to effectively regulate the market, it should seek other methods of mitigating the externality. Advocates of market-based policies for reducing negative externalities point to the difficulty of creating and enforcing effective regulation for reasons why the government should create systems of incentives and disincentives instead of using the force of regulation.
Corrective taxes incentivize economic actors to reduce the production of goods or services generating negative externalities.