Market failure is an economic condition where the market is not producing at the socially efficient level of output. Four elements of market failure include lack of public goods, monopoly power, imperfect information as well as externality. This paper will be focusing on one of the elements of market failure which is externality, specifically, negative externality.
Negative externality occurs when a production or consumption of any goods and/or services causes a negative external effect on a third party (Blink and Dorton, 2012). The term third party is used to describe a party who doesn’t take part in consuming nor producing the product in question. Based on the statement by Bowles et. al., market failure occurs “when firms don’t allocate resources in a Pareto-inefficient way” (2017). Pareto inefficient is when a misallocation of a property that has other alternatives in which there is at least one person would be better off but another person is worse off (“The CORE Project”, 2017). This essay will discuss both negative externalities separately to show a clearer difference between the two negative externalities.
Negative Externality of Consumption
Negative externality of consumption refers to negative effects that affect a third party due to consumption of a product (Blink and Dorton, 2012). For example, ‘consumption’ of cars contributes to air pollution which will negatively affect pedestrians or residents who live nearby busy roads. In turn, this external cost will lead to welfare or dead-weight loss since there is an allocative inefficiency. This is illustrated in Figure 1.
Based on Figure 1, the Marginal Social Benefit (MSB) curve is lower than the Marginal Private Benefit (MPB) curve since the third party which in this case is the pedestrian and residents are worse off compared to the consumers of cars. This indicates that the consumers kept using their cars even though it emits hazardous gasses and causes air pollution. Essentially, in the free market, consumers are aiming personal benefit over social benefit. As the market is producing at Q level of output instead of Q1, the market is not producing at the socially efficient level of output. This creates a welfare loss as illustrated in triangle ABC (refer to Figure 1) which will then create a market failure, thus we can conclude that the market is not allocating the resources in a Pareto-efficient way.
In the UK, for example, the government has taken some steps to enforce a law that stops the sale of all conventional petrol and diesel by 2040 as they are of many contributors to air pollution (Asthana and Taylor, 2017). Apart from that, the government is also in the process of building a new fund called Clean Air Fund (Atherton, 2017). These initiatives may reduce the negative externality on the long run. However, in the short run, it might not make a significant impact to alleviate the issue. Therefore, in the short run, the government may need to broadcast an informative advertisement on the potential threat of using private vehicles since it highly contributes to air pollution and health problems. By informing this to the car users, there is a possibility for a reduction of cars consumption in the short run, thus, the MPB curve could shift downward and closer to the MSB curve.
Figure 2: The shift of Marginal Private Benefit curve due to informative advertisement by government.
As shown in Figure 2, the car producers are now producing at Q2 level of output and is closer to the socially efficient level of output, Q*. There is also a reduction in welfare loss, indicating that pedestrians and residents are benefiting from cleaner air. Albeit the positive impact, the production level is still yet to achieve the socially efficient level of output because stopping cars consumption and enjoying totally clean air is almost impossible to be achieved in real life situation.
Negative Externality of Production
Negative externality of production occurs when a form of threat or external cost exists from a production of a good is affecting a third party (Blink and Dorton, 2012). For example, the production of cars emits greenhouse gasses (GHG) like carbon dioxide. Clearly, this poses a threat to the society as it is causing many health issues such as asthma, bronchitis, cancer and other kinds of problems including acid rain and the worst of all, climate change.
This problem that affects the society would then create a market failure as there is an existence of welfare loss as shown in Figure 3.
Based on Figure 3, the market is now producing at Q where MPC = MSB. MSC refers to the cost on the society regarding health problems and effects of climate change and MPC refers to the private cost of the firm excluding any external costs incurred by other stakeholders. To achieve the socially efficient level of output, however, the firm needs to produce at Q1 where MSB = MSC. We have to consider that in real life, firms are profit maximizing organisations, therefore, by producing at Q level of output, they can allocate the resources to a level that allows them to achieve their financial objective. However, by allocating resources in a Pareto-inefficient way, welfare loss (?ABC) exists in the market, hence, leads to a market failure.
The government will have to address this issue to reduce or eliminate the negative externality of which affecting the society. One of the many initiatives that the government has taken is imposing environmental tax to reduce carbon emission level as well as issuing tradable emission permit. The issuance of tradable emission permit is also conducted on the international level and will be discussed on the latter. In terms of the taxation, it would result in a shifting of the MSC curve to the left and reduction of the welfare loss as shown in Figure 4.
Figure 4: The reduction of welfare loss after carbon/environmental taxation is imposed
As shown in Figure 4, as tax is imposed, the MSC curve shifts to the left to “MSC + tax”. As a result, the output level of electricity decreases from Q to Q1, the socially efficient level of output while the price rises from P to “Price after tax”. Hence, when the firm is producing at Q1 and at the new price level, welfare loss could be abolished, hence there will be no deadweight loss.
However, the government would not be able to measure the cost of pollution emitted by each firm accurately. Therefore, it is possible that the amount of tax revenue gained is lower than the external cost that came from electricity production. This means welfare loss will only be reduced and not eliminated. On top of that, this step would not necessarily stop firms from emitting GHG during the production process considering that firms aim to maximize their profitability by producing at Q level of output.
The government could also provide tradable emission permit to the firms with the aim to reduce the environmental impact created in the production process. Based on the EU Emissions Trading System (EU ETS), each firm is given the ability to buy and sell its permit to other firms on a condition that the firms abide the quota of carbon emission set by the government. However, this may not be the case if there is no strict regulation regarding who sells the permit and how much carbon has every firm emitted. In real life situation, it is difficult for the government to monitor on whether the amount of carbon released in the atmosphere conform to the carbon ‘cap’. On the international level, the Kyoto protocol is also working on to reduce the global emission of greenhouse gasses that has been affecting the global community by issuing the carbon emission permit to developed countries. Unfortunately, however, this protocol also faces the same problem.
A real solution would be the government spreading awareness about the importance of reducing carbon emissions by running campaigns and subsidizing renewable energy, however, this will incur opportunity cost to the government as the fund could also be spent on other big economic sectors such as education and healthcare.
Based on the discussion above, there are very firm reasons that shows negative externality could lead to market failure. Welfare loss which is the core aspect of market failure exists when firms are not producing at the socially efficient level of output where MSC = MSB. The consumption or production that incur external costs too becomes a factor of welfare loss. By taking external costs into account, it It allows us to understand why
Furthermore, we can examine the limitations that the government might encounter when addressing negative externality given that in the free market, firms’ objective is to maximize their profit. Despite the firms’ of maximizing their profit, they can only produce at an allocative inefficient level of output.
This essay has also discussed the limitation of using economics model to address market failure as there is no absolute accurate way to measure the value of externalities.