Market failure is a result of Pareto inefficiency (Core Team, 2017). In other words, a failure to achieve effective allocation of resources (Kudelko M., Wejer W., 2014). Negative externalities fall in the pool of market failure, representing one of its numerous examples. In this essay I am going to outline the nature of negative externalities in the free market, particularly unfolding its mechanisms in an example, which incorporates pollution. Explaining in detail the welfare losses that occur when negative externalities are present in a market of production of a good or service. Subsequently I will be evaluating and analysing government policies, in the attempt to reduce welfare losses at the hands of negative externalities.
Negative externalities fall under the wider bracket of externalities. Stiglitz defines externalities of production or consumption to have “external effect – occurring- when a person or company takes action that has an impact – which may be positive or negative – on the situation of other people or companies (who are not compensated by corresponding payments)” (Kudelko M., Wejer W., p.2, 2014).In particular, negative externalities emphasise a reduction of an individual’s welfare due to the welfare of another party, therefore it underlines the cost of welfare loss, that is not accounted by the latter party that either produces or consumes the product (Kudelko M., Wejer W., 2014).This makes the free market unable to meet Pareto efficiency as they are unable to provide a feasible allocation, where at least one person is better off and no person is worse off, because one entity suffers the unpaid cost of the negative externality. (Core Team, 2017). However, Ronal Coase disagrees with the term externalities, he opposes the fact that external damages are deemed as social costs. He believes that damages are not sole unilaterally, he rather emphasises on the shared responsibility for the problem. As the social cost from a situation implies negative effects on both parties, because if an individual is made to cease production or consumption of a good or service to prevent external effects, they will be worse off, but if the consumption or production of a good is maintained the other party will bear the external cost. Therefore, he criticises the notion, that market failure is a result of Pareto inefficiency, but he rather points the finger at the inability of price mechanisms to incorporate compensations for damages (or benefits) that rise with the consumption or production of a good or service. (Neves V., 2012)
Figure 1. Negative externality (Source: Kudelko M., Wejer W., p.3, 2014) edited picture
In figure 1, we are going to consider the market for refrigerators based on two variables: price and quantity. Firstly, the private costs of manufacturing refrigerators incurred by the producer is drawn in figure 1. as the marginal private cost (MSP), which accounts for the cost incurred by the producer when he decides to produce an additional unit of the good, this does not include the costs of the refrigerator imposed to third parties (The Core Team, 2017). The production of refrigerators requires the use of metals, energy and additional chemicals to manufacture it. As a result of production some pollution is inevitably created, this is deemed as external costs absorbed by third parties. They face damage due to pollutants released in water sources and harmful gases release in the atmosphere that affect wildlife habitat, human health and even reduced property value that may affect another entity’s production and potential profit (Greenlay S. et al, 2017). It is mapped on the diagram as the marginal external cost (MEC), which is the external cost of producing an additional unit of output faced by third parties. The sum of the marginal external cost and the marginal private cost, which represent the total cost incurred by producing the refrigerator is represented by the marginal social cost (MSC), (The Core Team, 2017).
Pareto efficiency is achieved if the firm producing refrigerators sets its price at P* where the marginal social cost and the demand curve meet to produce quantity Q*, both the private and external costs will be absorbed by the price. It makes it a socially optimum choice as no unpaid costs are to be faced by external entities. However, in the free market the best feasible option that enables profit maximisation for the producer of refrigerators is not to set the price at P*, but rather at P1 where the firm can produce more output at Q1. However, the problem of Pareto inefficiency arises when P1 =MPC, because the price does not account for external damages, leaving room for overproduction of the good and consequently increasing external damages at Q1. (Sloman J. et al, 1991). This causes a loss of total surplus from the marginal social cost, it is represented in figure 1 by the area designated by the letter M. The lost total surplus is defined as deadweight loss due to the Pareto inefficient transaction that caused a reduction of utility at the part of third parties (The Core Team, 2017)
Nevertheless, a resolution must be evaluated (Buchanan J. & Vanberg V., 1988), before considering government intervention we must evaluate if private intervention is feasible. Private intervention, also called Coasean bargaining, consists of a negotiation to reach mutual gains by trading contracts and property rights possessed by each party. Coase argues that private bargaining is a better option as the parties at hand have greater information compared to the external entity that is the government that does not directly suffer from the causes of the negative externalities. However, it may not be a feasible option for multiple reasons including the cost of bargaining that consists of assessing information about costs and damages faced by each entity. (The Core Team, 2017) or the vast and future effect externalities may have on reserves (Baciu et al., 2015).
In these cases, government intervention is deemed as necessary to correct the externality. Government policies that can be implemented are regulation, taxation and enforcing compensation (The Core Team, 2017). Regulation is used as a method to discourage rising externalities in the forms of bans on the usage of certain chemicals or a cap on output levels. Each of these examples aim to reduce excess output produced by shifting quantity back to its optimum level, (Christiansen V. & Smith S. 2008). However, regulation can cause further loss to social utility by creating barriers for new more efficient businesses that try to enter a highly restricted and controlled market (Baciu et al., 2015). Taxation may present itself as an alternative, more popular form of government intervention. Pigouvian tax is an example of such, and it is described by Pigou as “the optimal marginal tax on a good that generates externalities – that – should be equal to the marginal social cost that arises from consumption or production of that good” (Hoffman F. et al, p. 2478, 2016). It ensures that produces face the social costs of their production choice, (The Core Team, 2017) by shifting excessive supply to under supply of the product creating the externality by imposing a tax that shifts the costs of production up to a socially optimal price level. In Figure 1 this is represented by P*, however the revenue maintained by the externality producing firm is not at P* multiplied by Q*, but rather the optimal quantity of production multiplied by the price level at P2 as it is the price level sold minus the tax implemented on production of the externality (Buchanan J., Vanberg V., 1988). In this way governments are able to reduce deadweight loss imposed on the firm using a tax on production, whilst receiving tax revenue from polluting firms that could possibly be redistributed as compensation for previous external damages caused. However, the taxing system would be efficient if the costs of pollution and production were constant. (Main R., 2010). These variables are not static like the diagram in which they are represented, but rather fluctuate (Duke M. & Sasson D., 2017), which means Pareto efficiency may not be achievable through a uniform taxation system and the potential loss of capital from producer surplus due to taxation, may deny potential investment in alternative methods of production (Hoffman et al., 2016). An alternative would be taxing emissions directly by measuring pollutants generated with production to achieve a socially optimum intervention. Although this option may be costly and an infeasible for the government, causing the government to be unable to truly eradicate market failure and achieve Pareto efficiency (Christiansen V. & Smith S., 2008).