How can government regulation address negative externalities? Give two approaches.

• A. Tariffs and quotas.
• B. Command-and-control limits and market-based policies like taxes or cap-and-trade.
• C. Relying solely on private negotiation.
• D. Subsidizing pollution.

Answer: (B)

When pollution creates costs for people who aren’t part of the decision, government regulation can raise the private cost of polluting to reflect those external costs. There are two main ways this happens.

First, command-and-control limits. The government directly restricts how much pollution firms can emit, or it requires a specific pollution-control technology. This forces all firms to meet the same standard, which reliably reduces pollution. But it can be inflexible and costly because the standard might not fit every firm’s situation or incentive for innovation.

Second, market-based policies like taxes or cap-and-trade. A pollution tax raises the cost of emitting pollution, encouraging firms to reduce emissions until their marginal cost of abatement equals the tax. Cap-and-trade sets a total emission limit and distributes or auctions permits that firms can trade; firms with lower abatement costs reduce more and sell permits, leading to cost-effective overall reductions. These approaches price pollution, providing firms with flexibility to decide how to meet the regulation.

These strategies address negative externalities by aligning private incentives with social costs, whereas policies like tariffs, subsidies for pollution, or relying solely on private negotiation don’t directly price or cap the pollution in a way that corrects the externality, and thus are less effective at achieving efficient outcomes.