Many economists favor tax penalties or effluent charges to curb environmental decay. This modified use of the market relies on price incentives to optimally allocate resources when externalities are present. Government sets the fee (charge) on pollution or the reward for reducing pollution, and polluters are allowed to adjust without overt coercion.
The effluent charge approach is illustrated in the figure above. Suppose that a group of polluting manufacturers is located on a public lake that could also be used for recreation and fishing. Water pollution reduces the enjoyment derived from boating, skiing, fishing, and picnics.
Assume that community leaders estimate external costs per unit of effluent at $1 when only optimal pollution occurs. To attain optimal rates of discharge into the lake, the community charges the firms $1 per unit of discharge. The MC curve shows the firms’ costs of reducing pollution. Given the $1-per-unit effluent charge, firms will reduce their effluents by E0 units. The firms will not remove more than E0 effluents because the removal cost (MC) exceeds the $1 effluent charge at quantities exceeding E0.
The government might also use subsidies (the opposite of taxes) to encourage pollution abatement. This is known as subsidizing abatement. Federal grants to pay for pollution control equipment have been used extensively to subsidize cleanups of sewage facilities run by state or local government. These sewer systems are now required to charge for their services based on measured use as a condition for receiving these federal funds.
Subsidies to private firms that reduce pollution ultimately subsidize the firms’ customers, but are unlikely to be effective unless the subsidies make abatement profitable. Subsidies to encourage private pollution abatement could take such forms as grants to pay for equipment, tax credits, or rapid depreciation allowances. Substantial political opposition to subsidizing private pollution abatement has, however, sharply limited such subsidies.