Problems of Externality and Government Policy Implication

Externality is the effects that industrial production and consumption has on the consumer (third party). In other words, externalities are costs or benefits incurred by the third party due to an action of economic agents. For example, when the steel company drains sledge into the river, it pollutes the river used for recreation. In economics, externalities affect the market equilibrium because; it makes the social marginal cost deviate from private marginal cost, which is associated with the action. Externality occurs due to several reasons, which include, the type of technology used. For instance, landscape could deteriorate because of transportation of electricity. In addition, externality could also occur due to interdependencies between producers and consumers at different stages. For example, a beekeeper who provides pollination services to the neighbor. Lastly, externality could occur because of networking, competition, and negative effects of the economic events. For example, an agreement between hotels and restaurants would stimulate the positive turnover at the end. Therefore, externalities produce either positive or negative affects to the society depending on how they affect the supply and demand, and allocation of resources in the market.

Positive externality is the benefits that the society gains from the producers although the producer cannot derive the profit from the gain made. For example, buying a pastureland near the urban area could make the land available for grazing or converted into residential houses. In the case where it is used for grazing, the public would benefit from grass without paying for it. The negative externality, occur when an economic agent costly affect the society and at the same time, cost producer nothing. For example, companies that pollute environment lose nothing, but the pollution affect animals and plants. Therefore, this paper would review the problems of externality and the implication of government policy.

Generally, externality could only prevail when the economic agents or welfare of the society depends on the activities of another agent. Thus, externality arises if the economic agents affect another, such that; the effect is presumed by the normal market behavior. That is, the interaction between the demand and supply curves. Actually, externalities are kind of market failure because when the scenario exists, the prevailing market price does not depict the true marginal cost or marginal benefits of the good or service as traded in the market (West 2010). Most economists argue that, “a competitive economy will not achieve a Pareto optimum in the presence of externalities because individuals act in their own interest” (Nunen, Huijbregts and Rietveld 2011, p. 60). One of the problems of externality is that, it has market failure. Market failure occur when the quantity supplied in the market is not equal to quantity demanded by the consumer hence the total social welfare of consumers is not satisfied (West 2010). In addition, the market fails to allocate resources thereby making the overall allocation inefficient to meet the growing demands of people. That is why in most cases, the government often use the policy intervention in attempting to internalize and correct the situation. In the case of production externality, the economic agents reduce the well-being of another economic agent who does not receive compensation in the process (Nunen, Huijbregts and Rietveld 2011). For example, when the steel firm pollutes air and water sources with by-products such as, sulphur dioxide or chlorine, there is always a huge health effect on a human being and aquatic animals.

Under the above circumstances, life expectancy of people would reduce and to some extent leads to death. For instance, in the Eastern Russia, poor water quality (polluted water) kills almost 3000 people annually (Hackett 2011). The negative production externality adversely affects production such that, the affected people suffer a great loss. To understand the extent of the effect, considering the private benefits and costs, and social benefits and costs would be appropriate. Economist defines private costs or benefits as the costs or benefits incurred or received by the actors: steel consumers and steel producers (Nunen, Huijbregts and Rietveld 2011). On the other hand, social benefits and costs are the private costs and benefits plus any costs and benefit accrued or received from actors outside the business setup (Nunen, Huijbregts and Rietveld 2011). For example, steel producers affecting the plant production in the lake for fish hence affect the fishermen indirectly. Economically, to realize the problem of externality based on costs and benefits, considering the market without externality, social marginal cost must be equals to private marginal cost (Gans, King, and Mankiw 2011). In the presence of externality, the social marginal cost is equals to private marginal cost plus marginal damage done by others. For instance, if each unit of steel production creates mire that kills $150 worth of fish, then the private marginal cost would shift upwards by the same margin ($150). That means that, fishermen would not get compensation for every unit production of steel, which imposes a cost of $150.

On the other hand, the private marginal benefits represent the market demand curve at which the consumer is willing to purchase a given unit of a commodity (Schmidtchen 2009). Nonetheless, the welfare consequences are represented by social marginal benefits, which is also equals to private marginal benefits minus any cost associated with consumption of the good. Therefore, the market fails to allocate production that does not create negative production but satisfy “social-efficiency-maximizing quantity” (Gans, King and Mankiw 2011, p.222). To eliminate the deadweight loss for the society, the market should allocate resources such that production and consumption becomes equal hence no extra cost in passed to the society (Arnold 2013). In other words, the social marginal cost should be less than the private marginal benefit so that, marginal damage becomes minimal. Furthermore, the externalities make it hard to factor in transaction cost that is incurred when moving resources from one location to the other (Schmidtchen 2009). Normally, moving resources from one location to another produces a net increase in the evaluation cost between the two locations because both the transportation cost and proportional cost are not the same with cost incurred during the transformation of input into output (Gans, King, and Mankiw 2011).

The presence of externality generates losses that makes the transport cost equals to the proportional cost during the medium of exchange (Gans, King and Mankiw 2011). For instance, considering that the steel producer is emitting a lot of smoke to the environment, which affect the drying of linen for the neighboring laundry, then, for the steel company to reduce the amount of smoke, the laundry owner acknowledges the transaction cost involved. As such, the cost would be relatively equals to the amount of desired smoke. Ironically, if the smoke is low, then it means that, the production would reduce. This would affect the output hence the market equilibrium would not attain the Pareto optimum. Economists argue that, if the externality exists between the two economic agents and it would produce much cost in terms of resources, then, it would force the emitter to incur or internalize the costs of the side effects of the it is actions, since this would result to Pareto- irrelevant case (Nunen, Huijbregts and Rietveld 2011). Assuming that, general equilibrium of a market depicts the normal production and utility function, and then the world becomes the distributor of the resources. In this case, the market would not eliminate the effect of externality hence the Pareto optimum would not be attainable. In fact, according to the economist, transaction cost ought to reduce since world provide perfect information where setup costs, bargaining and policing cost enters the private and public exchange (Hackett 2011).

The failures to solve the effects of externalities described above motivated the government to devise policies to correct or eliminate the failures. However, it is not always an easy task to draft appropriate policies to match the failures. The recent study by Vanhove (2011), pointed out that, most externalities would require multiple interventions to eliminate since some failures are complex in nature. For the government to achieve the economical goal then, “the combination of policy instrument that provide the greatest net benefit should be chosen” (Hyman 2010, p. 259). For instance, in 1970, in the United States, the government reluctantly used the Coasian solution because the government thought it was not sufficient to deal with large-scale externality (Vanhove 2011). The Environmental Protection Agency in U.S used the social optimum policies such as tax, subsidy, and restriction to bring sanity to the environment (Brigs 2011). In fact, the policy makers in U.S asserted that, “the choice of policy has implication for the distribution of economic benefits among producers, consumers, and government” (Coyne and Leeson 2009, p. 280). The policy used by the U.S targeted the output, input and any external generating activities that associate with the price of the product.

The externality tax also known as pollution tax is used to correct quantity of unit produced in the market to achieve the required production (Coyne and Leeson 2009). For example, if the government needs to regulate the production of a given product by imposing the tax, then, the tax would shift the marginal private cost with the same amount equals to tax, that is marginal private cost plus tax. For the producer, this increase would produce an incentive to the producer to lower the output in order to attain the social optimum (Nunen, Huijbregts and Rietveld 2011). Thus, the marginal externality would be equal to marginal tax. The pigovian tax has been used in most countries to mitigate pollution since producers lose a lot of profit to cater for taxes (West 2010). Mathematic economists agreed that, those producers responsible for any externality such as pollution should pay tax on every unit they produce or pay for production (output tax) that causes the externality or invest money in measures that control the externality (Free 2010). Although the key players (producers) advocate for the creation of “pollution rights” market so that they could evade paying hefty taxes, the pigovian taxes produce efficient market allocation hence appealing to the policy makers (Free 2010. P. 235). Therefore, through the tax policy, the market has been allocating resources efficiently and “improved information sharing to the pollution externality problem,” (Musgrave, Musgrave and Kacapyr 2009, p. 80).

On the other hand, imposing the sales tax instead of production tax, the demand curve for the firm would shift downwards, showing the net price of unit sold (Kaplow 2012). Thus, the net price is the marginal benefit of consumer less sales tax. Mathematically, it could be presented as NMB=D-t^* where t^* represent externality tax (Kaplow 2012). The second government policy that affects the production and consumption is subsidy. The government pays a subsidy to ensure that the people benefit from the product at the end. The mission for such subsidy is to reach the economic efficiency such that, both the company and the society do not incur the marginal cost of externality (Hackett 2011). That is, optimal social cost equals to private marginal cost, S* = t* = MEC (Q*). In the case of negative externalities, subsidy encourages some of the behaviors, which in the end, affects the economic well being of the country. However, in the case of positive externality, “firm’s solution of its utility maximization does not account for the additional utility produced as a by-product, thus causing the firm to produce less than the Pareto-sufficient level” (Brigs 2011, p. 848). In other words, the subsidy internalizes the externality so that the externality becomes the agent of the utility function. Although the policy intervention is lucrative for producers and consumers, it encourages black market and smuggling of goods to the market (Taylor and Weerapana 2012). This would create huge differences in price of essential commodities. In addition, the subsidy for pollution reduction would attract more firms into the market, which eventually would increase pollution at the end.

The third policy intervention is production quotas also known as command and control approach. The government restricts the quantity produced by the firm in the market. Under this intervention, the difference between consumer surplus and producer surplus is zero (Sandmo 2011). In other words, the government gets zero revenue. In most countries, producers prefer government restriction as opposed to externality taxes because, “the producers gain the larger share of total social surplus” (Schmidtchen 2009, p.310). However, for the government to operate efficiently, taxes have to remain high. In the case where the production quotas are transferable, the government could shift the quota rents to agents of economics such as poor students, consumers, or even government itself (Schmidtchen 2009). Under the normal market interaction (equilibrium market), the elasticity of demand normally affect the degree of inefficiency, which is associated with externality. However, if the demand curve is inelastic, the attainment of social optimal (level of production) is near the competitive level of production (Musgrave, Musgrave and Kacapyr 2009). Economist argue that, the inefficiency resulting from production externality is usually large and imposing regulations could be desirable (Musgrave, Musgrave and Kacapyr 2009).

Under the imperfect competitive market structure, producers normally produce too much of output for the market (Taylor and Weerapana 2012). However, when the marginal social cost is low, then the optimum output is low. Thus under the monopoly market, externality regulate the market output hence the optimal policy could work to subsidy the polluting monopolist to continue producing more polluting products (Taylor and Weerapana 2012). In the case where the monopolistic producers produce too much such that marginal social cost is high, then the tax policy would produce better results. That is, less would be produced for social gain.

In conclusion, externality is the cost or benefit incurred by the third party due to an action of economic agents. In economics, externalities affect the market equilibrium because it makes the social marginal cost deviates from private marginal cost associated with the action. Therefore, externalities are kind of market failure because when the scenario exists, the prevailing market price does not depict the true marginal cost or marginal benefits of the good or service as traded in the market. In the presence of externality, the social marginal cost is equals to private marginal cost plus marginal damage done by others. As such, most externalities would require multiple interventions to eliminate since some failures are complex in nature. However, those producers responsible for any externality such as pollution should pay tax on every unit they produce or pay for production (output tax) that causes the externality or invest money in measures that control the externality. The government to reach the economic efficiency such that both the company and the society do not incur the marginal cost of externality, it provides the subsidy. In addition, the government restricts the quantity produced by the firm in the market in order to eliminate the effect of externalities. Under this intervention, the difference between consumer surplus and producer surplus is zero. However, the tax on cigarettes and alcohol enables the government raise revenue, reduce the rate of infection and reduce the elasticity to be less than one so that the prices would be high for smokers. Therefore, government policies are able to contain the problems of externality although not at 100%.

References

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