Negative externalities of production

Negative externalities of production - external costs for third parties that are caused by the production of a product.

EXAMPLES:

• The production of electricity leads to pollution that causes health problems. Cost for healthcare providers. Can also cause climate change (rising sea levels and flooding). Cost for future generations.

• The production of red meat involves cattle farming, which contributes significantly to carbon emissions, climate change and future flooding. Cost for future generations.

Figure 1 shows the negative externality of electricity production with price on the y-axis and quantity on the x-axis. The free market equilibrium is where MPB=MPC (D=S) and quantity Q is bought and sold at price P. The production of electricity creates pollution which incurs costs on society due to poor health and increases healthcare costs therefore MSC is above MPC. Allocative efficiency is where MSB=MSC and quantity Q* is bought and sold at price P*. Q>Q* so there is an overproduction, creating welfare loss. This is market failure.

COMMON POOL RESOURCE

Common pool resource - a resource (something that firms use to produce other products)that is non excludable (it is impossible or very difficult or expensive to exclude people/firms from using it in a free market) and rivalrous (rivals=competitors people/firms are competing for use of the resource, because once one person/firms used it nobody else can - finite resource - sustainability).

EXAMPLES:

• Open water fish: in a free market, it is almost impossible to stop firms from fishing in the sea, and once one firm has caught the fish no one else can.

• Trees in forests

• The atmosphere

• The oceans

In the same way as with externality theory, producers are self-maximising: they attempt to maximise their own profits, and ignore society/fututre generations.

The tradegy of the commons occurs when individual firms acting in their own self-interests deplete or spoil common pool (shared) resources, leading to a loss of social surplus. The free market leads to a loss of social surplus; this is market failure.

SOLUTION 1: TAX (CARBON TAX)

• A tax paid by firms based on how much they produce/pollute.

• Production costs increase

• S=MPC shifts up by the value of the tax

• Price increases and quantity falls towards Q* → less pollution

• Welfare loss decreases

• If PED is inelastic, firms can choose the tax burden onto the consumer.

• Pollution will not reduce and low income consumers will suffer.

SOLUTION 2: SUBSIDIES ON RENEWABLE ENERGY

• A subsidy reduces costs for firms, and shifts S down by the amount of the subsidy to S + Sub.

• This makes solar panels cheaper (P to P1), giving electricity firms an incentive to switch from fossil fuels to solar energy, reducing pollution and threats to sustainability.

• Depends on whether the subsidy is big enough to make solar energy cheaper than fossil fuel, energy, making firms willing to switch.

Some firms may be reluctant to switch as they have default bias.

SOLUTION 3: NUDGES

• Default bias: when consumers are selecting which energy package to use, make the default option a sustainable energy program, which consumers have to opt out of.

• Research shows that many consumers stick with the default, even if non-renewable energy is cheaper. Pollution reduces, sustainability improves.

• Anchoring: inform consumers of their carbon footprint of their region, along with some tips for reducing energy consumption.

• Consumers anchor their views on the average and compare it to their own energy use. Research shows this can have a substantial impact on energy usage for consumers that use more than average, hence reducing pollution and improving sustainability.

• Information availability: advertise the impact of fossil fuels on climate change. When consumers are comparing energy providers, force companies to disclose what percentage of their energy is from renewable sources/from fossil fuels.

• Firms have an incentive to make as much of their energy renewable as possible, to attract customers. Pollution reduces and sustainability improves.

SOLUTION 4: COMMAND AND CONTROL

• Catalytic converters: all cars must be fitted with catalytic converters to reduce pollution.

• Green belt land/logging restrictions: trees are not allowed to be chopped down for wood on green belt land . This reduces deforestation.

• Fishing quotas:firms are not allowed to catch fish beyond a certain limit.

• Proposed for the UK - fine people for flying more than twice per year: limits pollution for the most frequent flyers.

Evaluation:

• It can be argued that the government should not need to impose rules.

• Instead, they should encourage that firms that will be impacted by threats to sustainability (e.g. all fish firms that want to fish in a certain area of water) to create regulations themselves.

• They have an incentive to do this so the resource does not deplete.

• Collective self-governance occurs when firms that use common pool resources are involved in making and adapting the rules regarding the use of these resources to prevent their over use.

• Is this possible with international problems like climate change? Too many firms!

• International cooperation to necessary to solve threats to sustainability.

SOLUTION 5: CAP AND TRADE SCHEME

• A cap and trade scheme occurs when the government sets a physical limit on the amount of pollution allowed in an economy by issuing a fixed number of ’pollution permits ‘ to firms, which may they be bought and sold in a free market.

• The supply of permits is set by the government at Q. This is the cap. If a permit is 1kg of pollution, only Qkg of pollution is allowed.

• Firms want to pollute, so they demand permits. There is now a market for permits, that is in equilibrium where S=D with Q permits bought and sold at price P.

How does it work?

• Firms who want to pollute must now buy permits, so must pay £P, increasing their costs. This is like a carbon tax, encouraging innovation.

• Firms who innovate can now sell their permits for £P, meaning they can collect revenue to pay for some of their costs of innovation. This is like a subsidy, encouraging innovation.

Evaluation: disadvantages

• How easy is this to enforce? If it cannot be enforced, firms continue to pollute.

• How severe are the punishment for firms that break the rules?

• Firms that produce necessities will just pay the additional costs and continue polluting, passing the higher costs onto consumers, making low income consumers much worse off.

• Where the cap is set is very important

• If it is too restrictive, it may punish the smaller firms that cannot afford permits or may encourage big firms to move abroad.

• International cooperation

• If it is too lenient, pollution remains high

• The government may need to continue to intervene - either issuing more permits (increasing S) or buying back permits (decreasing S)

Evaluation: advantages

• Even if the economy grows and more firms want to pollute, pollution will stay at Q! If enforced, pollution is guaranteed to reduce.

• The market ensures that pollution is allocated efficiently - only the firms that need to pollute the most will buy permits and continue to pollute.