4. a) With the aid of one or more diagrams explain why many forms of environmental pollution are
classed as market failure in economics.
Market failure occurs where the market fails to allocate resources efficiently. Negative externalities often
cause market failures. This means that the production or consumption of a good or a service will adversely
affect a third party. Negative externalities often arise when a good or a service is over produced or over
consumed, which means the good or a service is not produced or consumed at a quantity at socially
optimum level. Therefore, for example when talking about the negative externality of production, the
marginal private cost is less than marginal social cost, causing a larger quantity to be produced at a lower
price showing a welfare loss.
The production of energy from fossil fuels creates air pollution, which is clearly a negative externality, as
this will affect the residents around the energy plant. The consumption of airline services is also a negative
externality as it also creates air pollution as well as noise pollution. Thirdly, a chemical plant producing
fertilizers, which dispose their chemical waste in nearby waters is also a negative externality.
Externalities occur when the production or consumption of a good or service has an effect upon a third
party. If the effect is harmful, then it is a negative externality. Negative externalities occur in both
production and consumption. There is a negative externality where costs to society are more than the
private costs. Environmental pollution is a good example. If a paint factory emits fumes that are harmful to
people around the factory, then there is a cost to the society that is greater than the costs of production
paid by the firm. An example of this is society needs to spend money for people who need healthcare due
to pollution. Thus, marginal social cost is bigger than marginal private cost and a negative externality of
production is made. Another example is smoking. If people smoke in public areas, the smoke from
cigarettes will affect people in the immediate area. This is regarded as negative externality of consumption.
A negative externality of consumption occurs when marginal private benefit is bigger than marginal social
benefit.
Note that the market equilibrium occurs at Q1 in the above diagrams where MPC=MPB. Allocative
efficiency occurs at Q* where MSC=MPB.
Negative externalities of consumption make the marginal social benefits in each case less than
the marginal private benefits. The private utility is diminished by the negative utility suffered by
the third party. People who smoke enjoy private benefits of smoking, but will create external
costs in terms of pollution. The market equilibrium is determined by consumers consuming up to
a point where marginal private cost is equal to marginal private benefit (MPC=MPB). They
ignore the negative externality. Allocative efficiency occurs at that output where marginal social
costs equal marginal social benefit (MSC=MSB) This means that they over-consume cigarettes.
Since MSC>MSB, there is a welfare loss to society – market failure.
Negative externalities of production of a good or service creates external costs in the form of
pollution that is damaging to third parties such people’s health. Firms have private costs but also
produce external costs. Thus the MSC>MPC, Marginal Private Costs is below Marginal Social
cost. There is extra cost to society in the form of respiratory problems due to pollution. The firm
only produces where Marginal private cost = Marginal private benefit. This is market failure
because of the misallocation of resources. There is welfare loss to society of the extra units, the
vertical distance between MSC > MSB.
In a free market, this situation would continue, It is up to the government to change this
situation.
b) Evaluate alternative economic policies, which may be used to reduce the level of environmental
pollution.
To reduce the level of environmental pollution caused by consumption, the government may
choose to have negative advertising campaigns on environmental pollution, thus educate or
persuade consumers/producers to become more environmentally friendly.
The diagram shows the desired effect of advertising campaigns to discourage environmental
pollution cause by consumption. After advertising, the area of welfare loss has became smaller,
and the extent of negative externalities has decreased after advertising as well. Therefore, by
advertising the negative externalities (environmental pollution) caused by consumption, it is
possible that environmental pollution may be reduced.
However, though it seems that advertising is an effective way of reducing environmental
pollution, there are several problems. Since advertising campaigns are often very costly to
produce, the government will have an opportunity cost of allocating its government spending on
advertising rather than other public goods such as health care and education. Furthermore,
advertising may not be an efficient and effective way to reduce environmental pollution in the
short run as people tend to be selfish and even when they are made aware of pollution
externalities they choose to ignore them.
The government may also reduce the level of environmental pollution by increasing taxes on
goods and services that create much environmental pollution. Higher indirect taxes will lead to
an increase in production costs for the firm, which the firm may choose to transfer the costs to
the consumers by increasing the price of their products. Ideally, this will therefore lower the
consumption and production of the good or service, thus lowering the negative externalities of
production and consumption of environmental pollution.
However, if the demand of a good such as cigarettes is price inelastic, then the increase in price
of the good will only have a small change in quantity demanded and therefore, taxation may not
be an effective way to lower environmental pollution.
Furthermore, the government may also divert the tax revenue to those who are affected by the
negative externalities, such as using road taxes to build sound barriers and plant trees between
major highways etc. This way the government may be able to reduce the negative externalities
felt by the third party as well. Furthermore, the government may also divert the tax revenue to
those who are affected by the negative externalities, such as using road taxes to build sound
barriers and plant trees between major highways etc. This way the government may be able to
reduce the negative externalities felt by the third party as well.
A government may decide to use administrative or direct control policies to limit the amount of
pollution produced. They may do this by introducing tradable permits. A tradable permit is a
certain amount of pollution that is allowed to be created by each firm. Firms would benefit from
producing under the permitted amount as they can then sell their permits to those firms overproducing. They may also forbid the use of particular methods of production that may create a
lot of pollution e.g. mass burning of fossil fuels or the use of certain chemicals that are very
harmful to the environment e.g. CFCs, which contribute to global warming. They may also
introduce minimum standards of health and safety to protect workers and those third parties
who are affected by the negative externality created.
However, these policies are difficult to implement as the magnitude of an externality is hard to
measure and thus it is hard to define how heavily policies must be implemented in order to be
beneficial. Also, level of taxation is difficult to determine as taxes that are too high may cause
consumers and producers to suffer as output and consumption falls too much. Low income
consumers may be affected a great deal by these regressive taxation, whereas high income
consumers can continue to pollute. Structural Unemployment may occur. Taxes too low may
have no effect on production levels at all. Subsidies are also hard to determine as it is difficult
for a government to know what level of reward will give a firm the incentive to become “green”.
Taxes and subsidies are also expensive to implement and cause opportunity cost where the
funds could have been used for other government-funded projects like education and
healthcare. Moreover, pollutive products (like gasoline and fossil fuels) are demand inelastic.
Despite implementation of taxes and thus inference of taxes onto consumers resulting in higher
prices, consumers still demand the products as there are no substitutes. The “green”
alternatives are more expensive than the aforementioned product and are thus often
disregarded as a substitute. Tradable permits, while giving a firm a guideline of how much
pollution they are allowed to produce, may sometimes be disregarded as some firms can afford
to buy more permits to allow for inefficient or pollutive production.
As the cause and source of pollution in the environment all start with industrial wastes and so
forth, it is difficult to stop many firms from obeying with the law enforcements as many may
escape from it by not paying taxes, hiding out the contracts of the law enforcements and so on.
Parrallel markets may spring up to avoid indirect taxes.