Direct Regulation

When dealing with externalities, we typically see direct regulation as the government explicitly limiting or supporting an activity based on the types of externalities it creates. So, in the case of pollution being a negative externality of creating electricity, the government may directly limit the amount of electricity that power plants are allowed to create in effort of limiting the impact of the negative externality. On the other hand, some of the positive externalities associated with education are higher income and more informed voters; this gives the government an incentive to directly regulate how much education each citizen should receive.

However, the result of direct regulation is unlikely to be efficient. Using our power plant example above, consider the fact that some areas need more electricity than others (New York City has more demand for power than Macon, Georgia). By directly limiting the power output in hopes of lowering pollution, we would likely see a situation in New York City with a tremendous shortage of power, and an enormous surplus in Macon, Georgia. Theoretically, we would see a gradual move in New York where there are hundreds of small power plants creating the same amount of power and pollution as a few large ones. There are likely more negative externalities associated with having power plants scattered all over town (in terms of property value and poor health) as opposed to just a couple on the outskirts of town. Of course, this transition would be inefficiently expensive and it is very unlikely that a policy like this would last long enough for any transition to begin.

Even if the regulation was done by city or region, we also have to remember that different geographical areas have different access to power resources (coal, wind, sun, and water). So, we have to remember that it costs more for some areas to get the electricity it needs than others. Further, we have to consider that many parts of the world have found coal power to be the cheapest (not considering externality effects) making it even more difficult for regions/cities to comply with common electricity output limits or pollution emission limits (burning coal is one of the most environmentally hazardous ways of creating electricity).

Direct regulation is often referred to as Command and Control Policy.

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