Readers Question: Discuss the case for and against relying on the market mechanism to produce clean alternatives sources of energy that can replace fossil fuels such as oil and coal. (15)
Fossil fuels are non-renewable resources. Therefore, as they run out, the price will rise. This will create an incentive for firms to look for alternative sources of energy. Also, as prices rise, consumers will look for alternatives.
The higher price acts as a signal to firms and consumers.
- Higher price encourages consumers to look for alternatives to oil. For example, in the long-term, they may buy an electric car which doesn’t use petrol.
- Higher price encourages firms to try and look for new supplies (e.g. oil from arctic) or develop more fuel-efficient cars.
Therefore, the market does have a mechanism for responding to the shortage of fossil fuels.
Limitations of the market mechanism
Externalities of fossil fuels
Fossil fuels create negative externalities (pollution). The market mechanism fails to take these externalities into consideration. There is the overconsumption of negative externalities in a free market. Therefore, there is a case for government intervention to subsidise the development of alternative energy sources, such as solar power.
If an alternative fuel is clean, it creates positive externalities (less global warming) however, firms may not have sufficient incentive to develop these alternatives because they don’t get rewarded for the positive externalities of being clean. Therefore, to have the best future for energy, the government should subsidise the production of these clean alternatives (e.g. solar panel, wind).
Fossil fuels may not run out for many years. If you leave it to the market alternative fuels may not get developed until it is too late and prices are too high. The market only responds to current pressures and doesn’t consider long-term issues. To develop alternative years requires a long time of investment. The market usually has no incentive to think of the future; firms need profits in the short-run. Therefore, this is another reason for the government to be involved in meeting future long-term energy needs.
Problems of government intervention
There are drawbacks of the government intervening in the market for energy. Government intervention is often characterised by government failure. The government may have poor information about what type of subsidy to give. Working for the government may create inefficiency. Also, government intervention requires higher taxes. Therefore, it may be better to leave it to the free market.
Another market-based option is for the government to try and tax fossil fuels so that the price reflects the externalities involved. This will give incentives for the market to create alternative energy sources sooner.