It will not produce at the socially optimum level of output where MSC ( marginal social cost) is equal to MSB (marginal social benefit)
This represents a misallocation of resources. Too much is being produced at too low a price. This can be considered a type of market failure due to negative externalities.
The welfare loss to society due to extra units from Q1 to Q2 is represented by the shaded area
The second types of negative externalities are negative externalities of consumption
Negative externalities of consumption:
When a product consumed by an individual adversely affects a third party , it is known to have negative externalities of consumption
Examples include smoke from cigarettes, fumes from cars, alcohol , drugs etc
These negative externalities make social benefits less than marginal private benefits. Private utility is diminished by the negative utility suffered by the third party as shown below.
People who use cars enjoy private benefits but create extra costs for the people in form of smoke and pollution. In a free market , consumers will maximise their private utility by consuming where MSC = MPB. They do not care aout the negative externalities that they are creating. They will continue to buy Q1 cars at a price of P1. The socially acceptable output should be Q2.
Thus , the consumers are consuming Q1 to Q2 extra cars. Since marginal social cost is greater than marginal social benefit , it causes a welfare loss to the society and thus , has negative externalities.
In a free market , this situation will continue because consumers and producers are bothered only about their own private costs. The government needs to take measures to reduce these external costs of production .
Part 2
Evaluate three policies that may be used by government to reduce external costs of production.
Negative externality of production occurs when a firm creates external costs that are damaging to third parties.
Above is a representation of a car factory having negative externalities of production .We can clearly see from the diagram that the marginal private costs for the car factory are lesser than the marginal social costs. Thus, there is a cost to the society which is caused by the pollution of the air due to the industrial fumes generated by the firm. This may result in diseases like asthma, bronchitis , cancer in the community .The car firm will be only concerned with its private costs and continue to produce at Q1.
If external costs of production are not reduced by government policies, it could lead to market failure which needs to be prevented
The following actions can be taken to reduce these costs:
- It could tax the firm in order to increase the firm’s private costs and so shift the MPC curve upwards towards the point of social efficiency . If the tax is equal to the external costs of production, then the effect of the negative externality will be virtually nil. If the tax is not equal to the external costs, then it will at least reduce the deadweight burden. The welfare loss will be reduced.
For example, let us take the example of the car factory of General Motors Company.
The GMC company was producing at Qp and thus causing a welfare loss shown by the shaded area.
Then , a tax was imposed. It increased the private marginal cost of the firm. Therefore , the firm is forced to restrict output to Qs. This increases the cost benefits and reduces the welfare loss .
- The government could legislate and ban the polluting firms or restrict their output through legislations. It could also pass laws relating to measurable environmental standards in the firm’s production units. To meet the standards, the firm would have to spend money, thus increasing their private costs and forcing them to restrict output.
A problem with this solution is that the ban or restriction could lead to job losses and non consumption of the product which might be valuable . Also ,the setting and implementation of the policy standards may be long and debatable and might involve hidden costs.
- The government could issue tradable emission permits. These are a market based solution to negative externalities of production. These licenses are created by the government and give the firm license to create pollution up to a certain level. Once they are issued , firms can buy , sell and trade the permits on the market. The government decides on the level of pollution it will permit each year and then split the total level of pollution into aq number of permits which will be given to different firms.
The result is that if the firm pollutes higher than the quota, then it will have to buy permits from other firms which will raise its costs of production and thus force it to reduce production or to invest in Sustainable Development.