ChainWhat it assumes · how to break it
Start
The government limits a harmful activity by law, for example emissions standards for new cars or the ban on smoking in enclosed public places in England from 2007.
1
As a result, firms and individuals must keep the harmful activity within the legal limit or face penalties, whatever their private costs and benefits.
regulation
regulation
Assumes: The rules are enforced.
But: If inspections are rare and fines small, breaking the rules may be cheaper than obeying them.
2
This means the externality is reduced directly, without relying on buyers and sellers responding to a price.
negative externality
negative externality
Assumes: Firms genuinely comply.
But: Firms may meet the test rather than the goal, as when some car makers cheated laboratory emissions tests.
3
Consequently, output moves towards the social optimum, and where the harm is severe a ban gives a certainty about the outcome that a tax cannot.
social optimum
social optimum
Best link to attack
Assumes: The regulator knows the level of output where MSB equals MSC.
Assumes: The regulator knows the level of output where MSB equals MSC.
But: The regulator rarely knows the optimal level, and a uniform limit ignores that some firms can cut pollution far more cheaply than others.
4
Therefore, the welfare loss shrinks, though making every firm cut by the same amount costs more than a market-based policy that lets the cheapest cuts happen first.
welfare loss · efficiency
welfare loss · efficiency
Assumes: Abatement costs differ between firms.
But: Where all firms use similar technology, a uniform standard costs little more than a tax or permits.
End
The harmful activity falls towards the social optimum and the welfare loss shrinks, though not always at least cost.
Evaluation chain
- E1However, how close regulation gets to the social optimum depends on the regulator knowing where that optimum lies.
- E2Because abatement costs differ between firms and are known to the firms rather than the regulator,
- E3so a single standard forces some firms into very costly cuts while others could have cut far more cheaply.
- E4So regulation reduces the welfare loss and is best where harm is severe or hard to price, but taxes or permits may reach the same cut at lower cost.
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Questions this answers
- Explain how regulation can be used to correct a negative externality.
- Assess the effectiveness of regulation in reducing pollution.
- Evaluate regulation compared with taxation as a way to correct market failure.
Diagram
MPC, MSC and demand: a legal limit on quantity set at Q* removes the welfare loss triangle between Qe and Q*. If the limit is set wrongly, part of the triangle remains or a new one appears.
Reverse and related
Relaxing the regulation → the harmful activity rises back towards the free-market level and the welfare loss grows.