A tax equal to the external cost, tradable permits, regulation and minimum prices: how each works and how well. Through Northern Ireland’s carrier bag levy.
Northern Ireland brought in a 5p levy on single-use carrier bags in April 2013. In April 2022 it rose to 25p and was extended to every new bag priced at £5 or less. Shops pass the money to the Department of Agriculture, Environment and Rural Affairs, which spends it on local environmental projects. In 2025/26, 60.7 million bags were handed out under the levy.
How big should a tax like this be, and is a tax the best way to deal with pollution?
Sources: DAERA and nidirect; Northern Ireland Carrier Bag Levy Statistics 2025/26.
The problem with a negative externality is that the external cost is left out of the price. Governments can fix it in four main ways:
The tax diagram assumes the government knows the external cost and that it is the same for every unit.
Tradable pollution permits: the government sets a cap on total emissions and issues permits up to that cap. Firms that can cut pollution cheaply do so and sell their spare permits; firms for whom cutting is expensive buy them. The cap fixes the total; trading means it is cut where it is cheapest. The UK Emissions Trading Scheme has worked this way since 2021.
Regulation: laws ban or limit the activity, for example rules in Northern Ireland that stop farmers spreading slurry over the winter, when it is most likely to wash into rivers. Simple and certain, but it gives no reason to cut pollution below the legal limit, and it needs inspectors to enforce it.
A shop must charge 25p for every carrier bag.
Before, bags were free.
What is the main aim of the charge?
A free bag costs the shopper nothing, so they ignore the litter it causes. A charge puts a price on that external cost, so shoppers use fewer bags. It is an indirect tax used to correct a negative externality.
The problem from the last lesson: the market produces Q1, where MPC = MPB, beyond the social optimum, because producers ignore the £6 external cost of each unit.
Put on a tax equal to the external cost, £6 a unit. MPC + tax now lies on top of MSC. The external cost has been internalised: producers pay it as if it were their own cost.
Check: How big should the tax per unit be to reach the social optimum?
A tax equal to the external cost raises MPC exactly to MSC, so producers now face the full social cost.
The market now settles where MPC + tax = MPB, which is exactly where MSC = MSB: the social optimum, Q*. The price rises to P*, quantity falls to Q*, and the welfare loss disappears. Producers keep P* minus the tax.
The tax also raises revenue: £6 × Q*. It can be spent on cleaning up the damage, as the bag levy funds environmental projects. Using revenue for a named purpose like this is called hypothecation.
Get the tax wrong and the market misses. A tax of only £3 moves output to Q2: better, but still over-producing. A tax that is too big would cut output below Q*. Since the external cost is hard to measure, this is the biggest weakness of a tax.
Check: The government sets the tax at only £3, half the external cost. Where does the market end up?
MPC + £3 is still below MSC, so output falls, but not all the way to Q*.
The other tools. A minimum price set at P* stops the good being sold below it, so quantity demanded falls to Q*. Scotland has set a minimum price per unit of alcohol since 2018: 50p, raised to 65p in 2024. Unlike a tax, the extra money goes to sellers, not the government.
Each tool gives firms a different reason to cut pollution.
Check: Which of these gives a firm a reason to keep cutting pollution after it has done what the law requires?
Every tonne a firm cuts frees a permit it can sell, so cutting further always earns money. Under a legal limit, cutting below it earns nothing.
Which tool is best depends on the case.
Their tax is bigger than the external cost, so MPC + tax lies above MSC and output falls below Q*. That is over-correction, not the social optimum, which is where MSC meets MSB.
Explain how an indirect tax can correct a negative production externality.
With a negative production externality, producers ignore the external cost of their output, so the market produces where MPC = MPB, at Q1, which is more than the social optimum, Q*, where MSC = MSB.
[Diagram: D = MPB = MSB, S = MPC, MSC. A tax equal to the external cost shifts MPC up onto MSC. Output falls from Q1 to Q*, price rises to P*. Revenue rectangle between P* and P* − tax, out to Q*.]
If the government sets an indirect tax equal to the external cost per unit, it raises producers’ costs by exactly that amount, so MPC + tax lies on MSC. The external cost is internalised: producers now pay for it. The price rises to P* and output falls to Q*, where MSC = MSB, so the welfare loss is removed. The government also raises revenue equal to the tax times Q*, which can be spent on repairing the damage.
**Evaluation:** the external cost is very hard to put a money value on, so the tax may be set too high or too low. If demand is price inelastic, as for fuel, output falls only a little, and the tax mainly raises revenue rather than cutting pollution.
Carrier bag levy: DAERA and nidirect (2013 to 2026). Minimum unit pricing: Scottish Government (2018, 2024). UK ETS: UK Government (2021). Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed. Your answers are saved only on this device.