EXTERNALITIES.

Introduction

Economic activity, such as building a new factory or transporting a ship full of oil from Qatar to Japan, will affect those inside the business. However, economic activity can also have an impact on those outside. These are spill over effects, which can result from both production and consumption.

Definition; Externalities are costs or benefits resulting from activities of economic units (firms or consumers) but for which no compensation (payment) is made.

Spill over – is the effect that one situation or problem has on another situation.

Externalities are created when social costs and benefits differ from private costs and benefits.

COSTS

a)  Private cost

This is the cost of an activity paid for by the individuals, a firm, an area or a country which engage in a particular activity eg A firm making cars may incur the following private costs: the money cost it has to pay for raw materials, components, workers equipment or losses.

Private cost = social cost –external cost

b)  Social cost

ü These are costs suffered by society as a whole due to the actions of one party. For example, those who consume or produce a good meet private costs. For example; the private cost to a smoker might be the $ 100 per month that is spent on cigarettes. The external cost will be the discomfort and health risk that a third party might be exposed to as a result of inhaling cigarette smoke.

 Social Cost = Private Cost + External Cost (negative externalities

Note

If the social cost is greater than private cost, then a negative externality (external cost) is said to exist i.e

external cost = social cost – private cost.

Negative externality is an action or event that causes harm (adverse side effect) to be felt by others.

Examples of Social cost or External cost

1.   A firm making cars might cause a noise pollution (noise problem) for residents in the area of the factory. This is not a private cost for the company because it does not have to pay anything but it is an external cost because local residents have to bear this cost of production (noise pollution).

2.   If a chemical factory dumps waste into a river in order to minimize its cost. Further down the river a waste company has to treat the water to remove dangerous chemicals before supplying drinking water to its customers. Its customers have to pay higher prices because of the pollution.

3.   Too many cars on roads may lead to traffic congestions, accidents, damage to roads, noise and air pollution. Eg petrol fumes can cause asthma.

4.   Serious pollution problems eg dust particles from quarrying activities and emissions of greenhouse gases to the atmosphere which may lead to global warming.

5.   Huge monopolies may lead to consumer being charged higher prices.

6.   Production of dangerous and socially undesirable products, eg bhang, cocaine, heroine. People may also suffer from obesity and lack of fitness from eating too much of wrong type of food. (GMOs)

7.   Advertisements: misleading image which persuade consumers to buy the products eg pills, beer and cigarettes adverts.

BENEFITS

a)Private Benefits

These are the benefits received by individuals, a firm, an area or a country which engages in a particular activity.

Examples of private benefits include

Ø Revenue made after sale of commodities

Ø Profits earned

Ø Better wages for managers

Ø Prestige: a firm gaining status in the economy (Safaricom)

b) Social Benefits

These are benefits or gains to a society as a whole resulting from production activities by either individual’s firms or an area.

Social benefit = Private benefit + External benefit

Note: if the social benefits are greater than private benefits then a positive externality or external benefit is said to exist.

c)External benefit = social benefit – private benefit

Examples of Social Benefits

More Examples of Social benefits

1.   Production of useful goods and services which people wish to buy eg food, clothes etc.

2.   Creation of job opportunities eg. The income received helps to improve the living standards of the worker’s family.

3.   Introduction of new products and services that widen product range. Eg M-pesa, E – banking, E- commerce, internet services, etc

4.   Tax payments made by firms to government can be used to finance essential services such as free primary education, building roads, etc.

5.   Some revenue earned by firms can be used to sponsor needy students or charity walks.

6.   Street lighting and beautification programmes will also benefit the society as a whole.

Government Policies to deal with Externalities

A government will want to discourage economic activities that results in negative externalities and encourage those that results in positive externalities.

Policies to deal with/control externalities

1.  Subsidies

 A subsidy is a financial grant given by the government to the businesses in order to reduce the cost of production and increase supply and sell the supply at a cheaper price.

Ø It’s provided in order to encourage production and consumption of a particular good or service.

Ø It’s used as an incentive to reduce external costs.eg the government may give subsidy to a firm that builds a plastic recycling plant which will encourage people to recycle their plastic waste instead of dumping it.

Ø The government can also give subsidy to firms that generate external benefits.eg a firm that produces solar energy may be given subsidies which will increase more demand. if more solar energy is used to generate power then there will be less dirty energy produced hence reducing external costs hence benefiting the environment.

Ø The government may also give subsidies to university students inform of grants or loans to encourage them to further their studies to higher education.as a result the wider society will benefit from a better educated population.

However, use of subsidies may not be fully successful to reduce external costs due to the following reasons...

Ø Government subsidies may involve opportunity cost where the money spent on subsidies to reduce costs may have been spent elsewhere more effectively on other government projects.

Ø Government subsidies may increase its expenditure hence worsening their budget.

Ø The firms given subsidies might end up wasting the money instead of using it for the purpose it was supposed to be used for.

2.  Fines

A fine is a compulsory payment that is intended to punish or deter certain behaviors or activities.

 The government may use fines in order to reduce externalities. eg fines may be imposed on those who damage the environment eg those discharge waste chemicals into the rivers.

In Kenya, Mombasa County (2016) had introduced a fine on those who pollute the main tourist spots.eg dumping of litter by vehicle owners would have attracted a fine of ksh.250, 000.playing loud music would also attract a fine of ksh.200, 000.

However, it’s not successful because of corruption and lack of commitment from the government.

3.  Pollution permits

A pollution permit is a government document issued by the government to the businesses to give them right to discharge a certain quantity of polluted material into the environment.         eg 1 tonne per year.

Ø This permits are tradable, that is. A business can sell its pollution permit to another business if it has a found a way of reducing its own level of pollution hence the companies may make profits from trading the permits.

Ø A business that is struggling to control levels of pollution can buy permit to be allowed to discharge more polluting material legally.

However, using pollution permits has some difficulties such as...

Ø The government has to decide the number of permits to issue where it may issue either too few permit s or too many permits leading to the failure of this method.

Ø It is difficult to measure the amount of pollution and hence making it difficult for the firms to know which firm is polluting more than the other.

Ø The administration costs of permits are high hence the method may not be successful.

4.  Taxation

A tax is a compulsory fee paid by the individuals or businesses to the government.

Taxation can be used to reduce external costs of production.eg if a tax is imposed on a chemical firm that produces damaging emissions. This makes the production costs to increase and the prices charged by the firms will increase. This will lead to a decrease in demand for the firm’s product hence less production and less pollution. Taxes can also be used to reduce external costs of consumption.eg high taxes on cigarettes (addictive goods) will reduce the supply, which will increase the price. This leads to less demand for cigarettes and fewer third parties will be affected by the smoke (external cost reduce). This is successful when the demand is elastic.

However, since the cigarette are addictive goods when price rises due to increase in tax, demand may fall by very little.

5.  Government Regulation

Ø It involves the use of laws (rules) imposed by the government in order to reduce negative externalities. Failure to comply with the set laws can lead to heavy fines and imprisonment. Some of these laws include:

-        Aeroplane may be required not to fly near residential areas.

-        PSV (public service vehicles) is required to be fitted with the speed governors and safety belts.

-        Covid-19 rules etc

However, the use of government regulation may not be successful because of the following:

-        It’s not easy for companies and people to obey/follow rules.

-        The government may not have enough resources.

-        No commitment on the side of the government.

-        Government may lack commitment to enforce the laws or they may not have enough resources for enforcement.

-        Some companies that are responsible for pollution are powerful and have resources (MNC), they are prepared to stand firm against the government in case of a legal disagreements.