Limitations of markets

Taxation

Excise duties are placed on goods with negative externalities like cigarettes, alcohol and petrol. The idea is that this increases prices and so leads to a left shift of supply as firms have to give over more in taxes. This causes a contraction of demand. However these goods tend to have very inelastic demand and so this tends to have a greater effect on raising revenue for the government than reducing sales of the product.

VAT is charged at a lower rate on or not at all on some products considered to be essentials or to have positive externalities. Most fresh food, children's clothing and medicines attract no VAT while some energy saving products attract a rate of just 5%.

Effects of using taxation to correct externalities

VAT is a regressive tax. So are excise duties. This means they have a greater effect on low income earners than high. This is because they represent a greater proportion of income for a low earner. This means that while high taxes on goods with negative externalities may reduce their consumption they may also increase the gap between rich and poor. Reducing indirect taxes can have the opposite effect.

High taxes can lead to black markets for goods. Smuggled cigarettes cost the government loads of money in lost revenue and may have been made in unsafe or unsanitary conditions. Many counterfeit cigarettes that have been seized have been shown to have toxic chemicals in them.

As mentioned earlier, excise duties do more to raise revenue than quell demand. If this money is used to put towards the health services that will be needed this can be beneficial.

Subsidies

Subsidies are the governments way of making goods with positive externalities more appealing by lowering the cost to produce them. This leads to either a right shift of supply if the subsidy goes to the supplier or a right shift of demand if they go to the customer. Both are likely to increase the consumption of goods with positive externalities.

Effects of using subsidies to correct externalities

The elasticity of demand for a product will determine how effective subsidies are in increasing consumption. The benefit of subsidies is cheaper products but as with all government spending there is an opportunity cost to be considered. Some people may feel the subsidy money would be better spent elsewhere.

State provision

This refers to the services the education and health services that the government provides. These are considered to be basic needs. By providing them free for all, the government ensures everyone is entitled to healthcare and education raising the standard of living for those that may not otherwise be able to afford it.

Effects of using state provision to correct externalities

Private education and health providers are still available to those that can pay for them. In terms of education, it may be that even amongst government schools the quality of teaching may vary, with schools in deprived areas often underperforming those in more affluent areas.

With health care the government provides it free of cost but demand can be high leading to long wait lists for important operations. Those that can afford private health care are able to pay to avoid these queues.

Legislation and regulation

Legislation and regulations are the laws and rules that govern the way individuals and businesses behave in the economy. This criminalises guns, drugs and drink driving which can all lead to significant negative externalities for society. It also sets in place health and safety regulations firms must follow to keep employees safe and production standards that ensure consumers are not injured by defective products.

Effects of using legislation and regulation to correct externalities

Making things illegal can also lead to black markets for those goods. Ensuring that laws and regulations are enforced also costs money. So there is a trade-off between public safety and cost.

Information provision

The government often runs public service campaigns to promote positive externalities e.g. the five a day fruit and veg campaign and to discourage negative externalities such as campaigns about gambling addiction.

Effects of using information provision to correct externalities

The level of interest the campaign garners from the public will have a big effect on how successful this is. Goods with inelastic demand like cigarettes, alcohol and gambling are inelastic because of their addictive nature. It will be harder for these campaigns to convince people to quit.