How negativeexternalities are a form of market failure and the welfare losses that canresult from it and how government can intervene to address the market failure.Within this essay I shall investigatehow negative externalities produced by the consumption and production ofdemerit goods inflict an economic cost upon a third party. The production of harmfulcarbon emissions and the consumption of demerit goods shall be used as anexample to highlight how government can intervene to reduce the associatedwelfare loss.Negative externalities are theeffect of an economic decision, production or consumption, inflicted upon aperson, or people, “that is not specified as a benefit or liability in acontract.” (The CORE project, 2017) The production of pollutants resulting fromthe burning of fossil fuels produces negative external costs on societies,including pollution and environmental degradation due to carbon dioxideemissions. This is deemed socially undesirable as there is an external costbeing forced upon society. This externality results in the marginal social cost(“the cost of producing an additional unit of a good, considering both the costfor the producer and the costs incurred by others affected by the good’sproduction” ( The CORE project, 2017) varying from the socially optimum point,which is equal to the marginal private cost (“The cost for the producer ofproducing an additional unit of a good, not considering any costs itsproduction imposes on others.
” (The CORE project, 2017)) In this case anegative externality of production is incurred (as shown below in Figure 1). Figure 1- The Negative Externality Produced due to the Consumption of Fossil Fuels The negative externality producesa deadweight welfare loss, shown by the blue triangle in figure 1. In a freemarket, without government intervention, the output is at Q1 wherethe marginal private cost is equal to the marginal private benefit.
However,the socially efficient allocation lies at Q2, where the marginalsocial cost is equal to the marginal social benefit and a higher price of P2is charged. This results in a negative consumption externality wherein there isan overproduction of demerit goods. The negative production externalityhighlights the welfare gain which stems from reducing the output from Q1to the socially efficient Q2. In this case the producer ismaking a decision to use fossil fuels as a means of energy supply, whichinevitably results in air pollution, which effects people outside of the markettransaction. Whilst there is a private benefit this is much greater than theexternal cost meaning that there is a misallocation of resources, there is anoveruse of fossil fuels, causing a negative externality of production due toenvironmental spill over. P1 Negative Externality MSB D=MPB S=MPC=MSC Deadweight Welfare Loss Figure 2- The Negative Externality Produced due to the Consumption of Alcohol Moreover, a negativeexternality of consumption may also be incurred by the over consumption ofdemerit goods such as alcohol, cigarettes, junk food and gambling. The over consumptionof these goods results in costs to people outside of the market transaction. Usingalcohol as an example these costs include treating illnesses for alcoholconsumption, police efforts dealing with drunken behaviour and car crashesinvolving drunk drivers.
The negative consumption externality is shown in figure2. In the case of a negative consumptionexternality, in a free market, sin government intervention, output lies at Q,exceeding the socially optimum level of Qopt where the marginalsocial cost is equal to the marginal social cost. Here the negative externalityis the difference between the marginal social benefit and the marginal private benefit,therefore it can be said that there is an overconsumption of the good.
In order to “internalise” thenegative consumption externality from the consumption of alcohol, or the consumptionof fossil fuels, government must aim to reduce demand to the marginal sociallyoptimum. One method of doing so is to introduce a minimum price level of alcohol,a method that was planned by Scotland in 2015 where a minimum unit price of 50p.The main purpose of a price floor is to dissuade consumption.
Figure 3- The Market for Energy (produced via fossil fuels) Following the Introduction of a Price Floor The introduction of a price flooris vital in discouraging the use of fossil fuels as a means to supplyingenergy. By increasing the minimum price of carbon emissions to €30 per tonne,green and renewable sources of energy such as solar and wind become morecompetitive, thus reducing the negative externality (figure 1). The price floorwill also generate a producer surplus (figure 3) as consumers drop out of themarket due to the increased price. However, those which are not priced out ofthe market will are instead forced to pay higher prices, as the producers aimto shift the impact of the price floor onto consumers.
The price floor would lead to theloss of both consumer and producer surplus as producers are forced to sell atan increased price to a lesser demand and producers are forced to either buy atan increased price or drop out of the market. The loss of consumer and producersurplus at Q2 will produce a deadweight loss (figure 3).The price floor will also help totackle the negative consumption externalities produced by the consumption offossil fuels.
However, the burning and consumption of fossil fuels isrelatively price inelastic and it is not likely that a large proportion of themarket will be priced out. Therefore, it is unlikely that a price floor couldmove the quantity of fossil fuels used from Q1 at the market price of P1 to Q2,the optimum quantity for society, where there is no deadweight welfare loss andthere is allocative efficiency at a price of P2.Therefore, in the short term itis unlikely that the introduction of a price floor will be effective. This isbecause consumers will not drop out of the market until a suitable replacementis found, and so producers will benefit from the increased price of carbon andwill receive greater revenue of €30 per unit.
Since the energy produced bythese fossil fuels will be used in a variety of products the impact of theprice floor will be increased. Manufacturers of transport vehicles will beencouraged to find alternative methods in which to power their products tobecome more cost effective and competitive. In the short-term consumers willhave to suffer from an increased price of €30 per tonne of carbon or will beforced to switch to an alternative source of energy.
Consumers will have to payboth a higher price and will have less quantity to demand of Q2, figure 1. However,in the long term the consumers and society will have a lowered negativeexternality produced from the burning of fossil fuels.Moreover, producers which usefossil fuels to create energy will also be worse off as they are forced toproduce their good to a smaller demand and will have an excess of supply.
Producers must also pay the €30 per tonne of carbon tax which will result in afall in revenue.The government is the onlystakeholder which will undoubtedly gain from the introduction of a price flooron the carbon tax of €30 per tonne of carbon. The government will gain revenueequal to that which the firm will lose, increasing the government budget.
For the price floor to beeffective the minimum price must be set above the equilibrium price. The 30euro per tonne minimum price is likely to be effective in reducing consumptionof Carbon, as long as the price elasticity of demand for Carbon emissions isrelatively elastic. Given that the change in price is to be relatively large, demandshould be expected to decrease.
Whilst government may use marketbased policies such as a price floor or taxation, they may also applygovernment regulations such as tradable permits. These are pollution rightsissued to firms and cap the level of pollution from economic activities. Governmentmay increase the price of such caps to increase the opportunity cost to firmsthat pollute excessively, whilst the funds raised may be reinvested as governmentspending to further reduce the effects of pollution on society. Government may also introducelegislation to reduce the negative externalities associated with negativeexternalities. Examples of this include laws to regulate where and when peoplecan drive, drink and gamble or laws on the minimum age of alcohol and smoking. However,the problem of underground, black, markets may arise from this in addition to apossible reduction in the quality of goods affected.
In conclusion government may wishto combine both market based policies with legislation to make the consumptionand production of demerit goods in order to reduce negative externalities. Bothpolicies should be used in cases where consumption s price inelastic and theuse of a tax floor or tax may be unable to internalise the externality. Word Count: 1470ReferencesThe CORE project. (2017). TheEconomyHoang, P.
(2014). Economics forthe IB Diploma