Global warming is an issue that has recently been pushed to the forefront of political leaders debates and policy making. With temperatures at the end of the century that ‘might be up by anything from 1.1C to 6.4C’(Economist 2009) and the fact that ‘current average global temperatures are only 5C warmer than the last ice age’ (Economist 2009) there is some serious concern about the welfare of humans over the next century. However the predicament of global warming originates from economic theory. The fact that there has been such a detrimental effect on the planet from the extensive use of carbon dioxide emitting fossil fuels and ozone depleting chemicals shows that the private market is not capable of producing an economically efficient outcome. Externalities evolve when activities affect a third party who is not involved in this activity(Swann & McEachern 2006) and in this case it’s blatantly obvious that the rising world temperatures and its associated problems is an extremely large externality. This market failure comes about from the lack of private property rights, which are the exclusive right of an owner to use, rent or sell property(Swann & McEachern 2006). In this case there is no single entity that has ownership of the air or atmosphere and due to this no one can demand restitution for damaging it. Just as it was economic theory that explains the problem of climate change it also provides the solution. The government must take action in the private market and through implementing policies, internalise these externalities. This means putting a dollar value on the externality and having this reflected in its price. With the three main policies being subsidies, a carbon price through taxation and a carbon price through a cap-and-trade system, they all do this but reach their target with vastly different levels of efficiency and effectiveness.
A subsidy is an economic incentive offered by the government to individuals or firms to consume or produce more of a good or service (Swann & McEachern 2006). Its purpose is to increase the quantity of a good that produces a positive externality. As shown in figure 1.1 when only the private benefits are considered (P0, Q0) there is a dead weight loss present which is a loss of consumer or producer surplus which isn’t passed onto another economic party(Swann & McEachern 2006). If the government however is to intervene in this market and pay the extra money to consumers that the positive Price Quantity
D1 private benefit
D2 social benefit
Dead weight loss
externality is worth, (P1- Psub) then D1 shifts out to D2 as consumers now pay less (Psub). The economy now operates at an efficient level of (Q1, P1) where no dead weight loss is present. This same effect can be achieved if the subsidy were to be paid to the producer. By giving the subsidy to the producer their production costs decrease and the supply curve shifts(S1S2) and consumers still pay Psub. A major difficulty in issuing subsidies however is to correctly measure the initial positive externality. By introducing a subsidy that is not equal to the externality will result in a dead weight loss still being present. Subsidies also cause a problem where governments pick winners in the market, such that they are deciding who is to receive the extra money(Swann & McEachern 2006). Although they are acknowledging the positive externality, by only subsidising specific groups doesn’t allow market forces to decide and as a result drastically reduces their efficiency. There are also many examples of subsidies being wasteful with a perfect example being the American attempt at subsidising its farmers in corn ethanol that has just raised world food prices and added to the wallets of American farmers(Swann & McEachern 2006). The attempt to keep many American farmers with a job in...