Government Policies to Correct Externalities Revision Notes | GCSE OCR Economics

1. Quick Recap: What Are Externalities?

Before we look at how the government intervenes, let us quickly recap what externalities are. An externality is a cost or benefit that affects a third party — someone who is not directly involved in the production or consumption of a good or service. Externalities are a key cause of market failure because the free market does not account for these third-party effects.

Because the free market produces too much of goods with negative externalities and too little of goods with positive externalities, the government intervenes to try to move the economy closer to the socially optimal level of output. This lesson covers the main tools the government uses.

2. Policies to Reduce Negative Externalities

The government has four main tools to tackle negative externalities: indirect taxes, regulation, tradeable pollution permits, and bans. Each works differently and has its own strengths and weaknesses.

2a. Indirect Taxes

How it works: An indirect tax increases the cost of producing or buying a good with negative externalities. This raises the market price, which reduces demand and output. The aim is to make the price reflect the true social cost, so that consumers and producers take the external costs into account.

UK examples:

- Fuel duty: Around 53p per litre is added to the price of petrol and diesel to reflect the environmental damage caused by vehicle emissions.

- Tobacco duty: Cigarettes are heavily taxed (over 75% of the retail price is tax) to discourage smoking, which causes health problems for smokers and passive smokers.

- Sugar tax (Soft Drinks Industry Levy): Introduced in 2018, this charges manufacturers 24p per litre for drinks with more than 8g of sugar per 100ml. Many manufacturers reformulated their recipes to avoid the tax.

- Carbon tax: The UK Emissions Trading Scheme (ETS) effectively puts a price on carbon emissions from large industrial emitters.

2b. Regulation

How it works: The government sets legal rules that restrict the activities causing negative externalities. Firms or individuals that break these rules face fines, penalties or even criminal prosecution.

UK examples:

- Emissions limits: Vehicle manufacturers must meet strict emissions standards (Euro 6 standards). London's Ultra Low Emission Zone (ULEZ) charges drivers of older, more polluting vehicles.

- Planning laws: Factories cannot be built next to schools or hospitals without planning permission, reducing the impact of noise and air pollution on vulnerable groups.

- Speed limits: These reduce the negative externalities of driving, including pollution, noise, and the risk of accidents affecting pedestrians and other road users.

- Smoking bans: Smoking is banned in enclosed public places in the UK, reducing the negative externality of passive smoking on non-smokers.

2c. Tradeable Pollution Permits (Cap and Trade)

How it works: The government decides the maximum total level of pollution allowed (the cap) and issues permits to firms. Firms must hold enough permits to cover their emissions. Firms that invest in cleaner technology can sell their unused permits on the open market, creating a financial incentive to reduce pollution. Over time, the government can reduce the total number of permits, tightening the cap and further reducing pollution.

UK example: The UK Emissions Trading Scheme (UK ETS), which replaced the EU ETS after Brexit, covers around 1,000 of the UK's largest industrial installations and power stations. These firms must buy permits for each tonne of CO2 they emit.

2d. Bans

How it works: For goods or activities where the negative externalities are considered too severe, the government may ban them entirely.

UK examples:

- Single-use plastics: England banned single-use plastic straws, stirrers and cotton buds in 2020 to reduce plastic pollution in oceans and landfill.

- CFCs: Chlorofluorocarbons (which deplete the ozone layer) have been banned since the 1987 Montreal Protocol.

- New petrol and diesel cars: The UK government plans to ban the sale of new petrol and diesel cars by 2035, to reduce carbon emissions from transport.

3. Policies to Encourage Positive Externalities

Just as the free market produces too much of goods with negative externalities, it produces too little of goods with positive externalities. This is because the price reflects only the private benefit, not the wider social benefit. The government therefore intervenes to increase the production and consumption of these goods.

3a. Subsidies

How it works: The government pays part of the cost of producing or consuming a good, which reduces the price for consumers and increases the quantity demanded. This moves output closer to the socially optimal level.

UK examples:

- Renewable energy subsidies: The government subsidises wind farms, solar panels and other renewable energy sources to speed up the transition away from fossil fuels.

- Electric vehicle grants: Until recently, the UK offered grants of up to £1,500 towards the purchase of electric cars (the Plug-in Car Grant). The aim was to reduce transport emissions.

- Free school meals: Providing free school meals is a subsidy that ensures children from low-income families receive proper nutrition, which improves educational outcomes (a positive externality for the whole economy).

- Insulation grants: The government has offered grants towards home insulation to reduce energy consumption and carbon emissions.

3b. Direct Provision

How it works: Instead of relying on the private sector, the government directly provides the good or service itself, often free at the point of use. This ensures that the good is available to everyone regardless of ability to pay, maximising the positive externalities.

UK examples:

- The NHS: Healthcare is provided free at the point of use. A healthy population is more productive, takes fewer sick days, and creates less burden on social care — all positive externalities.

- State education: Education is provided free for all children aged 5-18. An educated population generates massive positive externalities: higher productivity, innovation, lower crime rates, and better civic participation.

- Public parks and green spaces: These provide health, wellbeing and environmental benefits to the whole community.

- Street lighting: This improves safety for everyone in the area, reducing crime and accidents.

3c. Legislation

How it works: The government passes laws that require people to consume goods or services with positive externalities.

UK examples:

- Compulsory education: Children must receive full-time education from age 5 to 18 (either in school, college, or an apprenticeship from age 16). Without this law, some parents might not send their children to school, leading to an under-consumption of education.

- Compulsory vaccination: While the UK does not currently mandate most vaccinations, many countries do. Vaccination creates herd immunity, a classic positive externality.

- Seatbelt laws: Wearing a seatbelt is compulsory. This reduces injuries in accidents, lowering the burden on the NHS (a positive externality for taxpayers).

4. Evaluation: Do These Policies Always Work?

A key exam skill is evaluation — being able to discuss whether government policies are effective and what problems they might create. No policy is perfect. Here are the main evaluation points to consider:

Difficulty of setting the right level: For taxes and subsidies, the government needs to know the exact size of the externality to set the tax or subsidy at the right level. In practice, this is extremely difficult. If a tax is set too low, it will not reduce the externality enough. If set too high, it may damage the industry and cause unemployment.

Regressive effects: Indirect taxes like fuel duty and the sugar tax hit poorer households harder because they spend a larger proportion of their income on these goods. This raises equity concerns.

Unintended consequences: Banning single-use plastics may lead consumers to use alternatives that have their own environmental problems. Subsidising electric cars may benefit wealthier households who can afford them, rather than those who need the most help.

Government failure: The government may not have perfect information and may make mistakes. Regulations may be poorly designed, subsidies may go to the wrong people, and enforcement may be weak.

International competition: Strict environmental regulations or high carbon taxes may cause firms to relocate to countries with weaker rules (carbon leakage), meaning global pollution does not actually fall.

Time lags: Policies take time to work. It may take years for a carbon tax to significantly change behaviour, and even longer for subsidies to transform an industry like renewable energy.

Worked example: Evaluating the UK Sugar Tax

The UK Soft Drinks Industry Levy (sugar tax) was introduced in April 2018. Manufacturers of soft drinks with more than 5g of sugar per 100ml are charged 18p per litre, and those with more than 8g per 100ml are charged 24p per litre. Evaluate whether indirect taxes like the sugar tax are an effective way of reducing negative externalities. [6 marks]

Method: Build an argument considering both sides, then reach a supported judgement

1. The sugar tax raises the price of sugary drinks, which reduces demand. According to the law of demand, higher prices lead to lower quantity demanded. This means fewer sugary drinks are consumed, reducing the negative externalities of obesity, tooth decay and diabetes. — Explain the basic mechanism — how the tax reduces the externality.
2. The sugar tax has been effective in changing producer behaviour. Over 50% of manufacturers reformulated their drinks to contain less sugar before the tax even came into effect, to avoid the charge. This directly reduced sugar consumption. — Use a real UK example to support the argument.
3. However, the sugar tax may be regressive. Poorer households spend a larger share of their income on soft drinks, so the tax takes a proportionally larger share of their income than it does from wealthier households. — Counter-argument: consider the equity impact.
4. It is also difficult to know if the tax is set at the right level. If it is too low, people may continue buying sugary drinks and simply pay more. Sugary drinks may also have inelastic demand for some consumers (especially younger people), meaning the tax has a limited effect on quantity demanded. — Discuss the difficulty of getting the tax level right.
5. Consumers might also switch to other unhealthy products not covered by the tax (e.g., confectionery, biscuits, fruit juices high in natural sugars), meaning the negative health externalities are not fully addressed. — Unintended consequences — substitution to untaxed alternatives.
6. Overall, the sugar tax has been partially effective. It successfully encouraged manufacturers to reformulate and raised public awareness, but it cannot solve obesity alone. A combination of policies — including education, regulation of advertising, and improved access to healthy food — is likely needed to fully address the externality. — Reach a balanced judgement — the exam rewards this.

Answer: The sugar tax has been partially effective. It reduced sugar content in drinks through reformulation and raised prices to discourage consumption. However, it may be regressive, may not be set at the optimal level, and consumers may substitute to other unhealthy products. A combination of policies is needed for full effectiveness.

5. Exam Success: Key Points to Remember

Top tips for externalities policy questions:

1. Always name and define the policy before explaining how it works.

2. Use the chain of reasoning: identify the externality, explain the policy, show how it corrects the market failure.

3. Include at least one UK example for every policy you discuss.

4. For evaluation questions, always consider: effectiveness, equity (who pays/benefits), unintended consequences, and whether the policy works better in combination with other policies.

5. Remember that no policy is perfect — the exam rewards students who can discuss limitations as well as strengths.