IB Economics SL & HLTopic 2.8 — Externalities & Common Pool ResourcesPaper 1 & 2Diagram skill~12 min read
Government Responses to Market Failure
Once you can show that a market is making too much or too little of something, the obvious question follows: what do you actually do about it? Every tool in this topic has the same target — move the market from Qe towards Qopt and shrink that welfare loss triangle.
📚 What you need to know
A Pigouvian tax is a tax equal to the external cost per unit. It makes the polluter pay.
A carbon tax is a Pigouvian tax charged per tonne of emissions.
A subsidy lowers the price of a good with external benefits so more is consumed.
Legislation and regulation set limits and enforce them with fines and bans.
Education shifts demand by changing what people believe about a good.
Tradable permits cap total pollution and let firms buy and sell the right to emit.
No tool reaches Qopt exactly, because nobody can measure external costs precisely. Reducing the welfare loss is still worth doing.
Taxing a negative externality
The logic is neat. If the problem is that a firm ignores a cost, make the firm pay it. A tax equal to the external cost per unit lifts MPC until it sits on MSC, and the market’s own selfish equilibrium lands on the socially best output.
This is the polluter pays principle: whoever causes the harm carries the cost of it.
Draw the tax so the new supply curve lies exactly on MSC. That single detail shows the examiner you understand what a Pigouvian tax is aiming at.
Notice that the tax does not ban anything. Firms are still free to pollute — they just have to pay the true cost of doing it. Being free to choose while facing honest prices is exactly what economists like about this tool.
Subsidising a positive externality
Flip the problem. If people ignore a benefit, pay them for it. A subsidy equal to the external benefit per unit pushes supply right until the market reaches Qopt.
Same target as the tax diagram, opposite direction. The market ends up at Qopt because the price finally reflects the full benefit.
The full toolkit
Tool
What it does
Best used when
Indirect (Pigouvian) tax
Raises price, cuts quantity, raises revenue
Goods are over-provided because of external costs
Carbon tax
Puts a price on each tonne of emissions
Production has a heavy carbon footprint
Producer subsidy
Lowers costs and price, raises quantity
Merit goods and clean technology are under-provided
Legislation and regulation
Sets limits and punishes breaches
The harm is serious enough that a price signal is not enough
Education
Shifts demand by changing beliefs
Merit and demerit goods, over the long run
Tradable permits
Caps total emissions and lets firms trade the right to pollute
Emissions can be measured and a cap can be enforced
Government provision
Supplies the good directly, free at the point of use
Public goods and badly under-provided merit goods
Tradable permits, briefly
The government decides how much pollution is acceptable in total, prints that many permits, and hands or sells them to firms. Each permit allows one tonne of emissions. A firm that wants to emit more must buy permits from a firm that emits less.
The clever part is what this does to incentives. Cutting emissions is now worth money, because unused permits can be sold. A firm compares the cost of cleaner technology with the cost of permits and picks whichever is cheaper — and either way, total emissions stay under the cap.
The honest criticism is that a permit is still a licence to pollute, and large firms can afford to buy up permits while smaller rivals cannot. If the cap is set too generously, permits are cheap and nothing changes at all.
Worked examples
WORKED EXAMPLE
Setting a carbon tax
A country’s power stations emit 40 million tonnes of carbon dioxide a year. The estimated external cost is $30 per tonne. Calculate the revenue from a carbon tax set at the external cost, assuming emissions do not change in the first year. [3]
Step 1: Tax per tonne$30, because a Pigouvian tax equals the external costStep 2: Revenue40,000,000 × 30 = 1,200,000,000Revenue = $1.2 billionStep 3: Comment
If emissions do fall, revenue falls too — and that is a sign the tax is working.
a shrinking carbon tax take is good news, not bad
WORKED EXAMPLE
Permits or cleaner technology?
A firm emits 620,000 tonnes but holds permits for 500,000. Extra permits cost $25 each. Cleaner equipment that removes the excess would cost $2,400,000. What should the firm do? [4]
Step 1: Permits needed620,000 − 500,000 = 120,000 permitsStep 2: Cost of buying them120,000 × 25 = $3,000,000Step 3: Compare with the equipment3,000,000 − 2,400,000 = 600,000Install the equipment and save $600,000this is exactly the incentive the scheme is designed to create
WORKED EXAMPLE
How much welfare loss did the tax remove?
Before a tax, output was 120,000 units against an optimum of 90,000, with a gap of $20 between MSC and MSB at the free market output. After the tax, output falls to 100,000 and the gap at that output is $7. Calculate the fall in welfare loss. [4]
Step 1: Welfare loss before(30,000 × 20) ÷ 2 = $300,000Step 2: Welfare loss afterbase: 100,000 − 90,000 = 10,000(10,000 × 7) ÷ 2 = $35,000Step 3: Reduction300,000 − 35,000 = 265,000Welfare loss falls by $265,000the tax did not remove the failure, but any reduction in welfare loss is a gain
💡 Exam tip
On a tax diagram, draw the new supply curve on top of MSC and say the tax equals the external cost per unit.
Use the phrase polluter pays principle. It is the standard term for this idea.
Never claim a policy “solves” market failure. Say it reduces the welfare loss and moves output closer to Qopt.
Bring PED into every tax evaluation. Inelastic demand means a small fall in quantity and a big revenue take.
Combine tools in your conclusion — taxation plus education plus regulation usually beats any single policy.
The three ready-made evaluation angles are: measuring externalities, effectiveness of the policy, and the impact on different stakeholders.
⚠ Common mix-up
Drawing the tax shift by a random amount. For a Pigouvian tax the shift must equal the external cost so the new curve sits on MSC.
Subsidising a demerit good or taxing a merit good. Check the direction of the market failure before choosing the tool.
Saying a tax raises revenue and cuts consumption a lot. With inelastic demand it does one, not both.
Treating tradable permits as a tax. A tax fixes the price of polluting; permits fix the quantity and let the price float.
Forgetting who pays for a subsidy. Taxpayers do, and that opportunity cost is a marked point.
Assuming education works quickly. It is powerful over years, not months, especially against addiction.
Up next: Collective and International Responses — what to do when the problem is bigger than any one government.
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