Economic Externalities And Market Failure - Essay Example

Economic Externalities And Market Failure Externalities are defined as a result of an action on a third party or the environment. This result of an action can be both positive and negative. Externalities can be created both out of production and consumption (Boyes 2008, 30). If an externality is being created out of production, then also it can be positive or negative. If we assume, that all goods consumed or produced are private in nature, that is to say that one particular individuals consumption or production of a good does not have an impact on the other, the question of third parties does not exist. However, if and when our actions do have an impact on those individuals who are not directly involved in the process of production or consumption, an externality occurs(Staaf et al 1972, 108). Every change in action or behavior carried out by an individual has some sort of an impact on the other, i.e., as one individuals behavior varies with either an increase or a decrease, so does another’s level of satisfaction or profit. It can then in turn, have either a positive or a negative effect on a third party individual who is not directly involved with the buyer or the seller of the transaction at hand.These costs (or benefits) are not included in the cost curve faced by the decision makers. For example, if I plant trees around my neighborhood, not only will I enjoy the benefits of having a street that is more cool and has more shade, but so will my neighbors, even though they did not have any part whatsoever to play in planting the trees. This is an instance of a positive externality. There are several instances that provide absolute evidence that the market economy is ploughed with enough imperfections and that it is unable to achieve economic efficiency (Lin and Steven 1967, 265). Economic efficiency is both productive and allocative efficiency. Productive efficiency is achieved when goods are made with the least possible amount of scarce resources, in other words, goods are made to the lowest possible cost. Allocative efficiency is achieved when the right amount of scarce resources are allocated towards the production of the right kind of products., i.e., when a combination of goods that leads to the maximum satisfaction of unlimited wants is produced, allocative efficiency is achieved. Therefore, the market fails to choose the right goods and services, and is unable to produce them well enough. Market failure is a concept pertained to economic theory, whereby the allocation of goods and services by a free market is not very efficient. That is, there is another plausible outcome through which the participants of the market can generate more gains from that outcome than losses(Davis et al 1997, 100). In a market economy where the main aim is profit, firms are competitive and are geared towards achieving productive efficiency in order to minimize costs and achieve higher profitability. However, allocative efficiency is achieved when limited resources in an economy are used to produce that combination of goods and services that maximize welfare. Most market economies are unable to produce those goods and services that satisfy the basic requirements and wants of the masses. It often concentrates on introduction of those goods and services which are preferred by those with higher disposable incomes rather than those who have lower disposable incomes. Thus, lower income groups are left unsatisfied and the uneven distribution of income and wealth continues to grow, leading to market failure(Winston and Clifford 2006, 76). Externalities directly lead to market failure. A negative externality basically occurs when a person or group’s actions cause harmful effects that are felt by others. If we take into account the costs borne by everyone, we get the total cost of production regardless of who bears those costs. Hence, total costs are an amalgamation of private costs and external costs. An example of negative externalities that deals with both consumption and production is that of pollution(Dobitz and Clifford 1971, 23). As a consequence, the costs to society, that is, the social costs, are not fully reflected in the costs to the consumer or the producer of the good or the service, that is, in the private costs. To further elaborate on it, lets consider a very simple scenario. The exhaust coming out of a car creates smog in the environment. However, it is not just the driver who has to breathe the carbon infested air, but also others. Hence, a negative externality regarding consumption has occurred. It should be considered that all of the costs associated with driving a car are not incorporated in the price of the car or the fuel, that is the external costs. These external costs should be added to the marginal cost of production to set the selling price. The government usually intervenes by curbing the negative externality, and in this case can do so by taxing the cost of gasoline or any other kind of fuel(Aldrich and Gwendolyn 2008, 233). Positive externalities basically occur when an individual or a group’s actions have a positive or a beneficial impact on a third party. In case of a positive externality, the benefits incurred by the individual producers and consumers are lesser than those realized by the society. That is, the socials benefits are greater than the private benefits. A very basic example of a positive externality is education(Iranzo et al 2009, 325). With education, there is a positive externality in terms of flourishing human capital and also, our entire society benefits from having a more well informed and educated population. Also, in future these individuals can benefit the productivity of firms and businesses by providing them with their invaluable input, and also raise families that can contribute effectively to society. In order to promote education and the welfare of society, the government can intervene by subsidizing education and lowering the costs of acquiring education to students so that even those who can’t afford it can benefit themselves and their society. Technology as well can be associated with direct costs and benefits. However, the social costs of technology lie in the fact that it can be useful more generally as well, than what it was essentially created for. Hence, there are positive externalities to the creation of technology. This is primarily the reason why most developed countries spend large sums of money in developing technology, because it is not constrained by issues of time and task. Also, third world countries can greatly benefit if they absorb technological knowledge, by reducing costs by a substantial margin. There are various economic policies that aim to address the market failure associated with positive and negative externalities(Cowen and Tyler 1988, 69). One of the most basic policies is the internalization of externalities. An externality is said to be internalized when the party that is generating the externality incorporates the external costs or the external benefits of their actions into their own cost-benefit analysis. This can be achieved by several different means. Many negative externalities occur because the parties that are creating them do not acknowledge the effects of their actions on others. In our example of pollution, if we inform these parties that are responsible for causing pollution the consequences of their actions and persuade them to alter their behavior, we may be successful in getting them to consider social costs in their cost benefit analysis. In order for such an agreement to be reached, however, the transactions costs associated with making the agreement must be lower than the expected benefits of the agreement. . Another policy that the government can impose to rectify negative externalities is taxation. The idea is to bring the price of the good to a level where it incorporates social cost, which can be done through the imposition of taxation. That is, taxing the good and raising its price when there is a negative externality. The government will implement a specific tax that is of same value as that of the social cost being incurred, to curb the externality or discourage the production or consumption. If there are direct taxes being imposed on the firm, the supply of the firm will shift inwards, and if on income, there will be a decrease in quantity demanded for the good. Indirect taxes will also affect production and consumption(Wijkander and Hans 1983, 9). The government can also use subsidies to promote an activity with positive externalities. A subsidy is a financial grant given by the government to a firm or an industry in order to decrease its costs of production. The purpose of giving a subsidy is to encourage production of a particular good or service. The rationale is to bring the price of the good close to its social benefit. That is subsidizing the good and lowering its price if there is the potential of an external benefit being realized. In our example of technology, the government can take up an industrial policy and should subsidize the development of productive technologies, so that the incentives to producing the technology can more closely correspond to the social benefit. In many countries, the governments have subsidized education in order to help the society grow more in potential in future. Another way to deal with externalities, in particular negative externalities, is for the government to use its authority and apply laws and regulations directly to those activities that are playing a crucial role in generating the externality. In our example of pollution, the government can intervene and impose control by, for instance, regulating the amount of polluting emissions being emitted by a particular factory. The government can simply set emission standards that limit the amount of pollution a polluter may generate. Other means of dealing with externalities privately more than publicly include preaching individuals about moral codes and social sanctions, whereby those causing the externalities think of their morals, values and ethics before participating in the production or consumption of a good or service that may inflict an externality, or remember their social obligations as a worthy member of society before doing so. The presence of voluntary organizations, such as, charitable groups and lobby groups can also contribute in educating people over this issue. In case there is no government intervention, the equilibrium point occurs where the supply(MPC) and demand(MPB) curves intersect. However if external costs are included in the diagram, the supply curve then becomes the MSC. The vertical distance between the supply curves gives the marginal external cost. This determines the socially optimal level of output, and at this level the marginal external cost is equal to the vertical distance. The government intervenes in the market and imposes a tax equal to the marginal external cost. This tax is also equal to the MPC plus tax, as the tax is added to the cost of production. Thus the supply curve MSC is equal to the MPC plus tax. Shrinking the revenue of the firm, will force it to use more environmentally friendly technology. To increase output. The extent of the social cost is the vertical distance, hence, the government will impose a tax of a certain value to raise revenue for itself to curb the externality and discourage production and consumption. It is fair to say that the existence of externalities itself is a market failure. When a government intervenes it is a bigger proof of market failure, as a free market economy should ideally operate solely on the basis of demand and supply forces, with zero government intervention. BIBLIOGRAPHY 1)Boyes, William J., and Michael Melvin. 2008. Microeconomics. Boston: Houghton Mifflin. 2)Staaf, Robert J., and Tannian. 1972. Externalities. N.Y.: Dunellen 3)Lin, Steven A. Y. 1976. Theory and measurement of economic externalities. New York: Academic Press. 4)Davis, J. Ronnie, and Joe R. Hulett. 1977. An analysis of market failure: externalities, public goods, and mixed goods. Gainesville: University Presses of Florida. 5)Winston, Clifford. 2006. Government failure versus market failure: microeconomics policy research and government performance. Washington, D.C.: AEI-Brookings Joint Center for Regulatory Studies. 6)Dobitz, Clifford Peter. 1971. Industrial negative externalities. Dissertation (Ph.D.)--Colorado State University, 1971 7)Aldrich, Gwendolyn A. 2008. Regulation of environmental externalities.Thesis (Ph. D.)--University of New Mexico, 2008. 8)Iranzo, Susana, and Giovanni Peri. 2009. "Schooling Externalities, Technology, and Productivity: Theory and Evidence from U.S. States". The Review of Economics and Statistics.91 (2): 420-431. 9)Cowen, Tyler. 1988. The Theory of market failure: a critical examination. Fairfax, Va: George Mason University Press 10)Wijkander, Hans. 1983. Correcting externalities through taxes on related goods. Read More