This is “Quotas”, section 7.3 from the book Beginning Economic Analysis (v. 1.0).
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The Pigouvian tax and subsidy approach to dealing with externalities has several problems. First, it requires knowing the marginal value or cost of the external effect, and this may be a challenge to estimate. Second, it requires the imposition of taxes and permits the payment of subsidies, which encourages what might be politely termed as “misappropriation of funds.” That is, once a government agency is permitted to tax some activities and subsidize others, there will be a tendency to tax things people in the agency don’t like and subsidize “pet” projects, using the potential for externalities as an excuse rather than a real reason. U.S. politicians have been especially quick to see positive externalities in oil, cattle, and the family farm—externalities that haven’t been successfully articulated. (The Canadian government, in contrast, sees externalities in filmmaking and railroads.)
An alternative to the Pigouvian tax or subsidy solution is to set a quota, which is a limit on the activity. Quotas can be maxima or minima, depending on whether the activity generates negative or positive externalities. We set maximum levels on many pollutants rather than tax them, and ban some activities, like lead in gasoline or paint, or chlorofluorocarbons outright (a quota equal to zero). We set maximum amounts on impurities, like rat feces, in foodstuffs. We impose minimum educational attainment (eighth grade or age 16, whichever comes first), minimum age to drive, and minimum amount of rest time for truck drivers and airline pilots. A large set of regulations governs electricity and plumbing, designed to promote safety, and these tend to be “minimum standards.” Quotas are a much more common regulatory strategy for dealing with externalities than taxes and subsidies.
The idea behind a quota is to limit the quantity to the efficient level. If a negative externality in pollution means our society pollutes too much, then impose a limit or quantity restriction on pollution. If the positive externality of education means individuals in our society receive too little education from the social perspective, force them to go to school.
As noted, quotas have the advantage of addressing the problem without letting the government spend more money, limiting the government’s ability to misuse funds. On the other hand, quotas have the problem of identifying who should get the quota; quotas will often misallocate the resource. Indeed, a small number of power plants account for almost half of the man-made sulfur dioxide (SO2) pollution emitted into the atmosphere, primarily because these plants historically emitted a lot of pollution and their pollution level was set by their historical levels. Quotas tend to harm new entrants compared to existing firms and discourage the adoption of new technology. Indeed, the biggest polluters must stay with old technology in order to maintain their right to pollute.