Externalities are a problem, and they will continue to be as long as the consumption of goods and services has third-party costs. The reason why they are such a big problem is that because no-one is accountable to deal with and lessen the effect of such externalities. No individual or firm is required to spend their resources, whether it is money or time, to reduce the extent of the externalities, in a completely free market economy. Here is where the government has to step in and impose ideas and regulation to deal with externalities. The government has a duty to make everyone in the country better off and thus they have to come up with ways to limit the impact of externalities.
Firstly governments can regulate the affected activity. The government issues thousands of pages of regulation every year on everything from groundwater contamination to meat inspection. Some regulations restrict the extent to where a house can be extended to, or how much CO2 a factory is allowed to release into the air.
However the idea of taxing the off-ending behavior, instead of banning it, is an idea that is favored by many economists. Taking the example of SUVs, the problem is that it is too cheap to drive them, as is the case for all vehicles. The essential idea is that the private cost is smaller than the social case. So raise the private cost. The only practical remedy, given the fact that driving SUVs causes damage to others because of pollution, is to give ourselves an incentive to take the damage into account when deciding what vehicle to drive. Impose a tax such as a gas tax, or emissions tax, in order to raise the private cost.
This however raises the question if it is appropriate to allow some drivers to pay for the privilege of driving a six tonne, pollutant spitting, and 4 wheel drive vehicle. Yes. The environment requires the same trade-offs as everything else in life. We should raise the cost of driving a SUV to reflect its true social cost and then let individual drivers decide if they want to still drive a SUV everywhere.
Taxing behavior that produces negative externalities creates a lot of good incentives. First of all it limits the behavior. Those who continue to drive SUVs after a tax has been imposed are those who value driving SUVs the most, and those who don’t, will stop, thus the extent of the environmental damage is limited. A tax also raises revenue, which a ban wouldn’t do. This revenue can be used to pay for the costs of the externalities, such as research in alternative energy. Or the extra money could be used to decrease other taxes such as income tax, which discourages behavior we would rather encourage.
In essence, taxing externalities is far from a perfect solution. The biggest problem is getting the size of the tax right, and this problem roots from the idea of government failure. The lack of information or information asymmety, of the exact cost of global warming to each driver means that the government doesn’t know how to much tax.
An exact value can’t be determined and thus taxing doesn’t work as a perfect solution. The problem of equity also arises because you have assumed that those who value a behavior more will keep doing it regardless of the tax. But our measure of how much we value something is based on how much we are willing to pay for it- and the rich can always pay more than everyone else can.
In conclusion, it is evident to see that the markets alone fail to make everyone better off when there is a big gap in social and private cost. The government is essential in fixing the rough edges of capitalism. But the government does more than that. It makes markets possible in the first place. Government is important in today’s market economies as they solve problems that the market would otherwise worsen.