Negative Externalities

Rahul Ganji

Economics

Explain the concepts of negative externalities
Evaluate three policies that may be used by government to reduce external costs of production.

An externality occurs when the production of a good or service has an effect upon a third party. There are 4 types of externalities: negative externalities of production, positive externalities of production, negative externalities of consumption and positive externalities of consumption. This paper shall examine the concepts of negative externalities of production.

As I mentioned earlier, an externality occurs when the production of a good or service has an effect upon a third party. If the effect of an externality is harmful, then we are talking about a negative externality. A negative externality of production occurs when the production of a good or service creates external cost that are damaging to other third parties. Let us see an example: Firms that manufacture paper are also involved in creating harmful chemicals such as dioxin. It has been suggested that this chemical is harmful, as they are major environmental pollutants. This cost to the community is greater than the cost of production. Thus, the marginal social cost is greater than the marginal private cost. However, firms cannot produce paper without this chemical, so firms pay for these external costs on top of the private costs of the firm. Also, external costs + marginal private costs=marginal social cost.

In this diagram, we see the marginal private costs are below the marginal social costs, because of externals costs that are created. The firm will be concerned with the private costs, so it will produce at Q1. Firms wouldn’t produce at Q2 because marginal social cost (MSC) will be equal to marginal social benefit (MSB), thus resulting in market failure. Resources are misallocated because too much paper is being produced at too low a price. There is welfare to society of the extra units (Q2 to Q1), because MSC is greater than MSB.

In a free market situation, profit ...

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In a free market situation, profit maximizing firms only take into account their private costs of production and therefore the government intervenes to rectify the situation.

In order to overcome market failure, the government intervenes and decides upon 3 things:

Taxing a negative externality
Making production illegal or restricting production
Issus trade emission permits

By taxing a negative externality such as paper, the firms private costs increase, shifting the MPC curve upwards. If the tax is equal to the external costs, then the government has “internalized the externality”. If not, then it reduces the deadweight burden, but doesn’t eliminate it. There is still a welfare loss, but it is less than that if government hadn’t intervened.

Look at the diagram below:

However, there are some problems to this solution. First of all, it is difficult to measure accurately the pollution created and putting a value on it, which can be regained by tax. Furthermore, it is difficult to measure which firms are responsible for polluting the environment and to what extent. It is also argued that taxes do not stop pollution from taking place.

The government can also ban paper production, or restrict output. This can be done by passing laws relating to measurable environmental standards. In order to do this, the firm will have to pay money, thus increasing private costs.

However, by banning or making paper production illegal (in this case) may lead to job losses and non-consumption of paper. This is a valuable product. Moreover, the cost of setting and then policing standards may be greater than the cost of pollution.

The third option the government can adopt is issuing tradable emission permits. These are market-based solution to negative externalities of production. This allows firms to create set amounts of pollution levels. Once they are issued, firms can buy, sell and trade the permits on the market. Each firm has a quota of emissions that it is allowed to produce. If any firm pollutes at a higher level that its permit allows, it buys from other firms which raises costs. On the other hand, if the pollute less than their permit, and then they are allowed to sell their permit and make a money.

The problem to this solution is that it does not lead to reduction in pollution; in fact firms simply pay the cost of polluting. Some pollute heavily and others do not! Also, the government faces a difficult decision when setting an acceptable level of pollution and it is often difficult to measure a firms pollution output.

Sources of diagrams