Negative Externalities Essay

Economics – Essay on Negative Externalities

A negative externality is defined as the (negative) impact on a party not involved with a given economic transaction. That is to say, the impact a good or service that is in the production would have on third parties. A non economic example of this would be if one sat in a room smoking a cigarette, the negative externality would be the negative impact of second-hand smoking ingested by the other users of the room, who don’t have anything to do with my smoking of a cigarette.

Negative externalities are usually environmentally related, such as air pollution, as no one person owns the air, or water pollution, as no one person owns the sea. An example of this would be if one shrimp farmer catches all the shrimp in the sea, then other companies have no access to shrimp anymore, and overfishing occurs.

An example of an individual providing a negative externality for others is if one decides to use a public transportation resource, such as a road, hereby causing congestion for other users of that road. Another example would be a car crash caused by a person under the influence of alcohol or drugs. The other party involved in the crash, who had been driving safely, would have negative externalities as they might be killed or severely injured.

An example of a business creating a negative externality is if it takes money from one area of the company, for example the marketing department, in order to fund another, for instance the pension department. The depletion of one department to provide for another falls into the category of moral hazards.

In situations such as the ones mentioned above, the marginal social cost is greater than the marginal private cost, because the costs are greater to the community than to the individual. This can lead to the good and/or service being over consumed. Without government intervention, the good and/or service will be under-priced and thus the negative externalities will not be taken into consideration.

In a free market, the government must sometimes intervene to stop marginal social costs (MSCs) becoming greater than marginal social benefits (MSBs). The government has several options to correct the situation.

The first option ...

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The first option is taxation. The government can tax the firm, in order to increase the firm’s private costs. By doing so, the government shifts the marginal private cost curve (MPC curve) upwards, towards the point of social efficiency. If the tax is then equal to the external costs of production, then the government has successfully internalized the external costs. If the tax, however, is not equal to the external cost, then it will reduce the burden, but not fully eliminate it. There is, in this case, still a welfare loss, but it is less than under the free market with no government intervention.

The second option is to legislate or ban polluting companies. The government can legislate or ban the polluting firms, or restrict their output in some way. It could also pass laws relating to measurable environmental standards in the firm’s production units. To meet the standards, the firms would have to spend money, increasing their private costs. Obviously, firms are not often willing to spend (more) money, and so they try to get around the bans and restrictions by looking for loopholes. Another problem with this solution is that it tends to lead to job losses, and the consumer not consuming the good that was originally made. The product may have been valuable, and thus this can cause problems in the economy. Also, the cost of setting and controlling standards may lead to greater costs than the cost of production.

The final option is to issue ‘tradable emission’ permits. The government could issue ‘tradable emission’ permits to firms that are polluting. These are market-based solutions to negative externalities and external costs. Tradable emission permits are government-issued and give the firms licence to ‘create’ pollution, up to a certain degree or level. Once these permits have been issued, firms can buy, sell and trade these permits on the market.

The government decides upon the level of pollution that it will permit every year, and then splits the total level between competing firms – rather like the allocation of scarce resources. The split pollution levels come out in the tradable permits, each allowing a certain level of pollution, which amounts to the country’s total level. Thus, a firm has a proportion of emissions that it is allowed to produce.

Since it is in the interest of the firms to pollute as little as possible, if a firm pollutes at a higher level than the permit allows, it will need to invest in more permits to cover their pollution costs, thus spending more money, and yet again increasing their costs. However, if a firm pollutes less than their permit allows, they can sell their permit and make money from that.

One problem with this solution is that it does not lead to the reduction of pollution, instead firms simply pay for the amount of pollution produced. Also, the government faces difficult decisions when deciding on the allowable amount of emissions. Do they allow more, and let it be a hazard to the community, or do they allow less, and decrease the amount of production? Also, it is hard to measure the exact pollution output of a firm, so more often than not they can get away with excess emissions.

One form of the tradable permits being used globally is the Kyoto Protocol. The Kyoto Protocol was an agreement made under the UNFCCC (United Nations Framework Convention on Climate Change). Its aim is to cut global emissions of greenhouse gases. The treaty was negotiated in Kyoto, Japan in 1997, and came into effect in February 2005. More than 163 countries are covered in the treaty, and over 65% of the emissions. Two notable exceptions are the United States of America, and Australia, who signed the treaty but did not ratify it initially. Australia, however, will be included in the full protocol by March 2008, now they have ratified it.

In the treaty, developed countries have agreed that by 2008, they will have reduced their greenhouse gas emission to around 5% below their 1990 levels. Developing countries have no obligations to reduce their greenhouse gas emissions, but they are in a position where they can be given tradable carbon credits (tradable permits) when they implement domestic greenhouse gas reducing projects. Developed countries are allowed to meet their greenhouse gas targets by purchasing carbon credits from developing countries who have earned them. Clearly, this is not an effective way of reducing emissions.

In conclusion, there is always a two-sided argument. The governments and firms face constant dilemmas, whether to spend more and dissatisfy the community, or spend less, reduce the emissions but decrease production, leading to a scarcity of resources. Unfortunately, the correct decisions aren’t always made, and indeed are not always possible. In these cases, the government and firms will often use the theory of opportunity costs to outweigh the two options. Eventually though, one poorly made decision can usually be balanced by an external party’s correct decision making, thus balancing out the problems. Although this leads to a stabilization of the reduction of emissions, it does not necessarily lead to the reduction of them, which is the government’s ultimate aim. As I write, it is 2008, and many countries have not successfully reduced their emissions according to the Kyoto Protocol guidelines. This is often due to economic reasoning – one of the main reasons behind the United States not ratifying the treaty. So in the future, we will have to decide – do we continue polluting, or do we cut down on production and more efficiently allocate what we can produce?