Problems That Involve an Externality (Such as Pollution) May Be

Problems that involve an externality (such as pollution) may be addressed by a number of alternative means. The most obvious is direct regulation, in which the use of some resource is directly limited by government. For example, pollution might be prohibited or limited to some fixed amount by direct regulation. Economists generally prefer some alternative solution to direct regulation, because regulation will not generally get persons to act so as to equate marginal social costs and marginal social benefits. Suppose it has been decided to implement a social policy to reduce electricity consumption by 10%, because the production of electricity results in pollution and consumes valuable resources.
(a) Give an example of how this goal could be achieved by direct regulation. What effect on incentives will the direct regulation you propose have? Will it equate the marginal benefits and marginal costs of electricity consumption? Why or why not?
(b) Now suggest two alternative methods to achieve the goal of 10% reduction in electricity consumption. What effect will these alternatives have on incentives? Will they result in the marginal benefits and marginal costs of electricity consumption being made equal?

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(a) The reduction of electricity consump...

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