In economics, market efficiencyoccur when the maximum amount of goods and services are produced with a limitedlevel resources, provided that no additional output can be produced withoutincreasing amount of input.
Efficient market is pareto efficient where theprice is equal to the marginal social cost. In some markets, buyer and sellershave influence in the control of market prices. This is known as market power.Stability of supply and demand can be affected by market power and causeinefficiency in market as it controls the the price and quantity. When acircumstance where the price mechanism leads to inefficient allocation of theresources and cause a deadweight loss of economic welfare is known as marketfailure. There are many causes of market failure; including monopoly power,negative externalities, imperfect information and public goods. When marketfails, government and public policy can interfere to potentially remedy theproblem and increase economic efficiency.
This essay will explore the negativeexternal effects as a cause of market failure, the welfare losses that occursand government intervention to address the market failure.According to CoreEcon textbook, external effects are defined as ‘a positive or negative effectsof a production,consumption, or other economic decision on another person orpeople that is not specified as a benefit or liability in a contract’.Therefore a negative externalities is an external cost suffered by a thirdparty as a result of a transaction. Producer and consumer are regarded as the first and second parties in an economictransaction. The third parties are any individual, organisation, property owneror resources that are directly affected by actions of consumer and producersattempting to pursue their own self interest. According to Adam Smith asexplained in his book “An Inquiry into the Nature and Causes of Wealth ofNations” , selfishness leads markets to produce whatever people want, to gainprofit, to get rich, you have to sell what public is eager to buy.
(Caplan)The selfishness of producers and consumers cause negativeexternality can cause the marginal social cost to exceed the marginal privatecost.The graph above shows the effect of negative externality. Without considering externality thequantity is at Q1 which is the pareto efficient quantity of goods produced asthe marginal social cost and the marginal social benefit is equal. When thereis a negative externality, there is an external cost because the producers donot take responsibility for the external cost, the cost is beared by thesociety. Thus the supply curve is effectively shifted to the right because theproducers have lower marginal cost.Now that the supply curve has increased,more goods are produced than the efficient amount, the good produced withnegative externality is Q. Since marginal social benefit and marginal socialcost are not in equilibrium there is a deadweight loss.
The firms producinggoods at Q which is more than the socially efficient quantity Q1 is what causesthe market failure.Negative externalities happen when social cost exceed theprivate cost of goods. Marginal social cost is defined as “the cost ofproducing an additional unit of a good taking into account both the cost forthe producer and the cost incurred by others affected by good’s production”.
(Project) Thus marginal socialcost is essentially the sum of the marginal private cost and marginal externalcost. The red area in theabove graph shows the deadweight loss or net welfare loss due to market outputsupplied is greater than the social optimum. Net welfare loss exist in twosituations.
First, it exist when the marginal cost to society is greater thanthe marginal benefit of a particular economic activity to society. Secondly, ifthe marginal benefit is greater than marginal social cost. (Negative Externalities, n.
d.) In the case of negative externalityrefers to the first situation as the market over produce goods that generateexternal cost. Any output between Q1 and Q creates a net welfare loss becauseof external cost or pollutions emitted.As explained above, negative externalities occur when thirdparties outside the market are affected by production or consumption for whichno compensation is paid.
Most common example of negative externality ispollution. For example, the harmful effect of passive smoking on non smokers(third parties) by smokers which may cause health problems and increasedspending on medical bills. Furthermore, the noise pollutions neighbours have toface when music is turned on loudly which causes disturbance to community. Thesenegative consumption externalities leads to social benefit is less than privatebenefits. Externalities also occur when there is no allocation on propertyrights over assets and resources, or not predetermined thus uncertain. Forexample the ocean, the air that we breathe are not private property of anyindividual.
There is no ownership and rights allocated to them, so ships canpollute the ocean without being afraid of being sued in court, Air pollutionfrom traffic congestion do not take into account the harmful effects to peopleinhaling the air, leading to prolonged illness such as lung diseases. (Alvi, 2017).Negative externalities in goods or services cause the entiremarket fails to operate effectively. This is because the cost inflicted toother people that failed to be taken into account by individuals who incur thecost and the way their actions are affecting and impacting others. Government,due to ownership of industries, has power to prohibit the products and theirrelated activities that causes negative externalities. However, there aresituations where externalities may not even be corrected because positive andnegative externalities are related to each other. For example, mowing lawn is an act of grooming appearance of household is a positive externality but the noise of the lawn mower gives a loudnuisance noise to your ears which is a negative externality.On negative production externalities, governments can imposelarge fines and restrict the amount of pollution being dumped.
There arepollution permits by the Emission Trading Scheme(ETS) that can be bought andsold in order to put some financial pressure on the firms emitting pollutionand causing negative externalities. Government could also grant property rightsas pollutions in the environment happens because there are no property rights.According to Ronald Coase in his Coase theorem, allocating property rights willencourage the appointed owners to protect the resources by allowing them to suewho exploit the resources (Lack of property rights, n.d.). For instance, theNational River Authority which is now a part of Environment Agency was givenpowers to act ‘as if’ it owned the UK’s rivers. This allowed them to police therivers and sue the polluters of rivers and illegal poachers. Negative consumption externalities can be prevented bygovernment intervention by imposing regulations, levying tax and usinginformation and nudge theory.
Regulation and Laws can be implemented to reducenegative externality in a market. The Health and Safety at Work covers allbusinesses. A ban on smoking in public places was placed by the BritishGovernment in 2007 was in effort to reduce the effect of smoking on passivesmokers.(Health Act 2006,s.
28) Prohibition of public consumption of alcohol andnoisy unruly neighbours can be taken action by Local Councils as they can passbye-laws. Information and nudge theory can be enforced by the government byputting warning on cigarette’s packets to discourage people from smoking. Correctivetax can be imposed to make consumers pay full social cost of the goods.Therefore reducing consumption and create a more socially efficient outcome.Negative externality, if not corrected will cause overconsumption because theyignore the external cost. Goods equal to external marginal cost should have atax placed.
Thus, consumers will end up paying the full social marginal cost.As shown in the graph below, after tax is imposed, the quantity of output fallsfrom Q1 to Q2 because the price is increased with tax price. This situation is considered socially efficient becauseSocial Marginal Cost(SMC) is equal to Social Marginal Benefit (SMB). (Tax on Negative Externality , n.d.)