Negative Externality… Negative Externality…

Whenever there are side effects caused by the private action that can have an impact on other people in crucial ways, we have the problem known as, externalities. The problem arises when it’s a negative consumption and/ or production externalities because there is no such market for them e.g.; noise, air or contamination. Due to the competitive markets it can become inefficient when the externalities occur, therefore government play’s a crucial role by making policies in an attempt to correct, the externalities.

Externalities are a cost or the benefits arising from the economic transactions that can have an impact on the third party, and they aren’t taken into account by those whom undertake that particular transaction. In market economy externalities generally occurs where ever there is a direct effect of the actions of one person or the firm on the welfare of another person or firm in a way that isn’t transmitted accurately through a market system.

There two forms of externalities positive and negative, and negative production externality happens whenever the production of a good develops a cost borne by the person outside the production of that good. Simple example of that could be, air pollution that occurs through the production of oil by the oil refinery, the air around the suburb will get polluted and makes the community living close to oil refinery worse off, by diminished health or effect the ability of seeing a clear blue sky and stars at night, etc…

The graphs below shows us that the firms only going to take into account only their own marginal cost that increases the firm’s cost when it produces one or more unit of a goods and hence it will produce where marginal benefits is equals to marginal costs. It indicates that supply equal demands. Referring back to our example of oil refinery it would produce at a point A where it indicates that (Quantity=Q1: Price=P1). However, there are social costs associated with it like (air pollution) in the production of oil, which is ignored by the oil refinery. In the presence of negative externality social cost curve have to be higher than marginal cost curve. The original production value of the oil refinery company will indicate that their social benefits are higher than their social benefits and therefore the quantity are inefficient and that leads to market failure. Market failure occurs when market participants don’t account factors within the full social costs of their harmful economic activities. Moreover there are some opinions between social cost and marginal costs about out these which one of is related to the negative externality. If you look at the graphs you will probably note there is no such externality on the consumption side of the graph, thus meaning that marginal benefits=social benefits depict that demand curve will stay the same. As we know that when externality exists, economic efficiency will always exist whenever social benefits is equal to social costs. If this is the case, economic efficiency will occur at Point B. The area that is shaded in which social cost exceeds the social benefits costs is simple caused by the overproduction, another words it’s deadweight loss which is the fall in the total surplus that is resulted from a market distortion, like taxes or tariff. Society is better off if the economy were to be at point B rather than point A. Notice that at point B, the effective solution isn’t to decrease the harmful activity to 0. If the firm have capabilities to compensate the parties affected it completely and still have profit remains, then the pollution is worth it to the society. Although it’s very unlikely for an oil refinery to stop polluting the atmosphere depict that even if the quantity produced were to be below Q2, the benefits got from society were to be greater than the social costs, It can assumed that society is better off if the firms produces more polluting products.

Than on the other hand we have negative consumption externality which occurs due to the consumptions of a certain goods or services. The example of that would be, smoking. By smoking in public area, the consumer is doing passive smoking, which than leads to negative externalities. There are health cost that are associated with smoking like the smokers health cost is shared by the society, than there is a cost of family support (assuming in the case of early death), finally there is a risk to non-smokers. So you see consumption externality occurs when individual’s consumption of good imposes costs on others that aren’t transmitted through the market and in the case of smoking the smokers causes non-smokers to pay for their medical support through taxes thus imposing cost on others.

In negative consumption externality, the MPB and MSB are parallel to each other, but however MSB lies below the MPB. The vertical gap between MPB and MSB is where negative externality lies. The best level of consumption is achieved when MSB=MSC i.e. Q*. However if we were to ignore negative externality than we can face the over consumption of the good as indicated at Q1.

Finally, due to competitive market in today’s society if externality to occur it will cause the markets to become inefficient, this were government plays a crucial role in creating policies to reduce the impact of negative and/ or consumption externality. In order to maintain the correct level of negative externality the government can bring down the production to the right level government can intervene through the following policies.
Legislation and regulations by applying this policy government can pass on the legislation to decrease the effects of the production externalities. These legislations will limit the quantity of goods produced by the firms and bring down the production to the required optimal level where Q* by causing a shift in the MPC curve upward towards the MSC curve. The legislation might include the following things that the firm must limit their amount of emissions of pollution by setting limits to the amount of pollution that can be produced by the firm. Limit their production to an acceptable level and finally forcing the highly polluting firms to install the renewable technologies which can reduce their emission level. The other policy is to put taxes (Pigouvian Tax) it charges producers a tax that is equivalent to the production of externality or per unit of pollutants emitted. It can increase the firms marginal private cost up to the level of marginal social cost, and therefore reducing the level of output and bringing the production level that is socially to its optimal level. i.e. Q*. As shown in the diagram below the impact of the taxes have.

Then there are Tradable pollution permits these permits are cost-efficient market-driven approach towards the solution to reduce the amount of CO2 emitted each year. It involves the concept of issuing firms pollution permit, telling them that just how much tons of particular gas they can produce with in pacific amount of time and the other interesting thing about this scheme is that firms can sell these permits to each other in exchange for money. Economically speaking a firm can reduce its amount of pollution and then sell its pollution permits to firms whom it would be difficult to reduce pollution, and those who find hard to cut their emission may find themselves buying extra permits, trading of it will keep on continuing until all profitable trading opportunities had been exhausted. But Tradable on permits will result in reduction in the quantity of goods produced so that can be equal to Q*(referring to negative consumption externality graph), and also it raises price tag of the goods.

Then there is advertisement government can get through the heads to individuals through advertising/ awareness campaigns to let the consumer know about the consequences of the products. Thus it will lead to a MPB shift curve to the left hand side hence reducing the gap between socially optimal level of consumption Q* and Q1.

Government can also impose indirect tax on the production of the certain goods that can cause negative consumption externalities; government can reduce the supply, by putting taxes on certain items this will cause the supply curve (MSC) to shift upward to MSC+tax, and hence reduce the gap between the Q* and Q1.

Finally than there is a concept of assigning property rights it can be achieved by letting parties negotiate and come up with a solution to their externality issues. It can be solves using the Coase theorm which states that whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient, it’s a better than the government-based solution because it can provide market based-solution to externality rather than government –based problems which is fraught with practical problems due to the imperfect information on government data base.

To sum than externalities causes the market to become inefficient and therefore the market fails and negative externality In production or consumption lead the market to produce more than what is socially demanded. As we by now knows that the social cost of the production or the consumption are greater in comparison to the marginal benefit or marginal cost by the producer and consumers and hence this leads to the market failure by externality. But then there are some policies than can stop the market going into market failure. So it’s really up to us weather we can let them keep on producing and pollute our planet or do something about it after all if there is no planet there is no YOU.

Bibliography:

1. F. John Reh, 2012. Pareto's Principle - The 80-20 Rule: How the 80/20 rule can help you be more effective. New York: New York times company. http://management.about.com/cs/generalmanagement/a/Pareto081202.htm (accessed on 25/4/12).