Unit 2.8·Microeconomics

Government Responses to Externalities

Market Failure: Externalities and Common Pool Resources

AO2·AO4·Diagram required

Syllabus requirement

Includes Pigouvian taxes, carbon taxes, legislation, subsidies, public provision, tradable permits, education, and international agreements.

Assessment objectives

AO2 Application and AnalysisAO4 Use of Appropriate Skills

Required diagram: Diagrams showing government interventions such as indirect taxes, subsidies, carbon taxes, legislation, and education. Highlight changes in quantity, price, and reduced welfare loss.

Summary

This section explains how governments respond to externalities using policy tools such as indirect (Pigouvian) taxes, carbon taxes, legislation and regulation, education (awareness creation), and tradable permits. It shows how these interventions aim to internalize external costs or boost external benefits, shifting market outcomes toward the socially optimal quantity and reducing welfare loss. The text also outlines advantages and drawbacks of each tool, and provides diagram-based analysis of price, quantity, and welfare effects. Real examples illustrate effectiveness, revenue implications, and distributional issues like regressivity.