Discuss whether taxation is the most effective solution to the market failures arising from negative externalities [18]

Negative externalities occur when production or consumption impose external costs on third parties outside of the market and no compensation is paid. E.g. noise pollution from airlines in London. Taxing business’s for the negative externalities they cause means charging the business’s for the external costs they impose on third parties. One reason why taxation is the most effective solution to the marker failures arising from negative externalities is because by raising the costs of production for the business, they are forced to reduce the supply of their products, so therefore the problem of overproduction is solved. This can be seen in the diagram. The original quantity supplied is shown by the line S. When the tax is imposed, they will have to decrease the quantity they supply shown by the leftward shift if supply curve from S to S3. This means that because the quantity supplied has decreased, it will result in a decrease in negative externalities for third parties, e.g. less noise pollution from aeroplanes because there are less planes. However, if the firm’s products are price inelastic demand, then they will be able to increase the price they charge their consumers so they can maintain their profit margin. Therefore the polluter doesn’t end up paying for the negative externalities, so the externalities won’t have been solved and will be ongoing. This will happen because when the price of a price inelastic product rises, the percentage increase in price is greater than the small percentage decrease in demand, e.g. domestic business flights. Domestic business flights are a necessity for a lot people in the US, so the increase in price won’t decrease the number of tickets they buy. Another reason why taxation isn’t the