Negative Externalities in Economics: Research Essay Assessment 2 Answer
A Research Essay
The following report discusses the concept of negative externalities in economics. Further, the case for government intervention, whether it should be there or not will also be discussed with various ways in which negative externalities can be addressed.
In order to understand the concept in a better way, the report will also make an effort to identify a case of negative externality in Nepal and discuss the same in light of various economic concepts, such as, the impact, addressing the externality and identification of market structure.
An ideal market is not always achievable in real world. Sometimes, the available resources are not allocated in most efficient manner due to many factors, such as, lack of perfect information, lack of clear property rights, bargaining issues, high transaction costs, etc. This situation is known as market failure (Arrow & Debreu, 1954).
For example, we all breathe air and know that we cannot survive without it. However, none of us will be ready to pay for the air that we breathe even when we understand that it is very important and valuable for our very survival. Since air is owned by all, no one is ready to pay for it and wants to benefit from it for free. This is a case of common property where rights are not clear leading to misuse of the property. Since air is free, we do not care whether we are polluting the air in one way or the other and may even over-use it leading to stress on environment. Through the lens of economics, a feasible solution to tackle it is to make air chargeable. However, in real world, it is not possible due to ownership rights being vague and exclusion of certain individuals who do not pay being very difficult. Such situation lead to inefficiencies in resource utilization and in turn, a market failure occurs (Gravelle & Rees, 1992).
When a market failure occurs, it needs an intervention to rectify the failure or, at least improve allocation of resources. Typically, this intervention is by the State (Arrow, 1951).
Broadly, different variety of market failures can be listed as below:
- Externalities: The most common type of market failure, it was first introduced in the book ‘The Economics of Welfare’; it refers to a situation where one person’s action impacts another person. This impact can be positive or negative. The party that creates the impact is known as agent and does not need to pay (in case of negative externality) and does not get paid (in case of positive externality) (Pigou, 1920). This will be discussed in further sections in detail.
- Public Goods: As the name suggests, these goods are owned by all and used by all. No one is willing to pay for them. In turn, no one is willing to produce these goods as there are no buyers for the same. This is also known as Free Rider problem where everyone will like to use a good or service but not pay for them. A unique feature is that the amount available will not reduce for others even if a person consumes it more and further certain people cannot be excluded from consumption of these goods as the goods are freely available. For example, if a street light is turned on, the light can be used by passers-by as well as by a person reading a book. Even after this, kids can use the light to play in the area (Buchanan, 1967).
- Market Control: In a market, the buyers and sellers bargain to get maximum profits for themselves. Hence, sometimes, when a particular buyer or seller is dominant in the market, he/she may maximize profits at the cost of the other party. This is particularly true when a market formation is a monopoly (or monopsony) and oligopoly disturbs the equilibrium state of the market. In such a case, the other party is exploited due to profit maximization of dominant player.
- Information Asymmetries: Sometimes, a market failure occurs due to lack of information availability for either of the parties. For example, when a patient visits hospital, he/she does not have information about diagnosis which may lead to hospital taking advantage by prescribing unnecessary tests etc. This will maximize hospital’s profit by increasing bill at the cost of patient (Beesley, 1997).
The concept of externalities was first introduced in 1920 in ‘The Economics of Welfare’ and is one of the most frequently occurring market failure. A unique feature is that the agent does not get paid (or does not pay) for crea
tion of impact for other people.
The impact created by agent’s action can be favourable in which case a positive externality is created. In case the agent’s action is adverse, a negative externality is created. Usually, the property right of the resource used by the agent is unclear.
For example, when a person burns coal or wood in winter season to get some warmth, the person is damaging health of those around him/her b emitting smoke. Further, the environment is also damaged as there is air pollution. From this situation, we can say that a negative externality related market failure has occurred where the person causing it is responsible for damage to others (Pigou, 1920).
Diagram below explain negative externalities:
Source: Pigou (1920)
In above case, let us take example of a car that is emitting carbon dioxide leading to air pollution through carbon emissions. The negative externality is the pollution that impacts health of those driving behind the car.
- Marginal Social Cost: It is the sum total of marginal private cost and marginal private benefit
- Marginal Private Cost: It is the direct benefit to the customer consuming a unit of good.
In this case the social cost is created which is ideally equivalent to cost of negative impact of carbon emission by the car.
Government Intervention & Pros/Cons
In case of any type of market failure, including negative externalities, an intervention is required to address the failure and/or improve resource allocation. Typically, this intervention is state-led. State intervention mainly comprises of policies, legislations, taxes and subsidies (Bator, 1958).
In order to control negative externalities such as the impact of cigarette smoking, a government can impose taxes on tobacco consumption, making the commodity more expensive and thereby, reducing its demand and corresponding externalities.
In the above case of car emissions, the government can impose taxes equivalent to the cost borne by others. The revenue generated from this tax should ideally be used to nullify the negative externality thus created.
The tax so imposed is also known as Pigouvian tax after the British economist, Arthur Pigou, who developed the concept. According to him, government should impose a tax on anyone creating negative externality that impacts the society. Further, the revenue so generated should be used for societal benefit as a whole. There are multiple real-life examples of Pigouvian tax such as (Amadeo, 2019):
- Carbon Tax: Imposed on companies using fossil fuels such as, coal etc.
- Gas Tax: Imposed on use of fuels such as, petrol, gasoline and revenue generated is used for maintenance of roads.
- Noise Tax: Typically imposed on airlines operating in busy airports and revenue generated is used to soundproof houses exposed to high noise levels.
There are many advantages as well as disadvantages of such Pigouvian taxes:
Main advantages include:
- Discourages negative behaviour: Imposition of taxes discourages negative behaviour by the consumer such that no or less negative externality is created. For example, if a car emitting pollution is slapped with taxes, it increases cost for the car driver. Hence, he/she will look for alternatives, such as using public transportation, less frequent use of the car or getting a car which is emission-compliant. This will ultimately benefit the society by decreasing pollution level.
- Ensure higher economic efficiency: By addressing the negative behaviour in a successful manner, such intervention helps to make the economy more efficient. The revenue generated from the tax imposition is used for betterment of the economy by nullifying the damage caused to society.
- Additional Revenue: The government may be able to minimise the cost of nullifying damage to the society and tax revenue saved can be used for other projects for society betterment.
Main disadvantages include:
- It is difficult to quantify the damage cost: The first and foremost disadvantage is that the concept is based on imposing tax equivalent to the cost of damage caused by negative behaviour. However, in real world, it is very difficult to quantify the cost of damage in dollar terms.
- Disadvantageous for lower income groups: In countries that are less developed, it may be seen as very harsh to impose same level of tax on all people irrespective of their income level. For example, for the poorer sections of the society, a particular tax may be a very heavy percentage of their income, thereby, making them at a very high disadvantage.
- Can be counterproductive: In order to counter the above mentioned point, the government may try to exempt certain sections of the society such that it creates unrest among those who are within the ambit of the tax. This creates inefficiency and sometimes, government may be unable to implement the tax itself.
The selected case study is from the brick industry that is thriving in Nepal. The handmade bricks industry is growing such that there are more than 200 brick kilns in Kathmandu itself. In Nepal, the number of kilns is estimated to be more than 1,000 with a total investment of more than $37 million. Further, since it is a valley, the particulate matter from the kilns is restricted within the valley due to limited wind movement. The kilns are mainly dependent on fossil fuels such as, coal and wood.
The effect of brick kilns can be understood from the fact that the concentration of particulate matters is 300% more in peak season of the industry as compared to concentration in off-season. Further, the industry is booming as the construction sector expands in Nepal and the demand for bricks also increases correspondingly.
Hence, brick kilns are one of the major causes of air pollution in the valley. Not only pollution, the particulate matter leads to reduced visibility, reduced soil fertility and even water pollution. Further, the brick kilns do not provide the best of the working conditions thereby, exposing the labourers to respiratory problems and other health issues leading to lower mortality rates. Apart from this, the labourers are paid minimally and even children are involved in working in dangerous conditions (Shah, 2016).
Hence, the industry creates multiple negative externalities, including environmental damage, health damage and exploitation of labourers through low wages.
Addressing the Issue
There has been no formal intervention by the government. However, various frameworks have been provided by the ministry and such framework has been prepared in collaboration with the Federation of Nepal Brick Industries (MinErgy, 2017).
Further, there are programmes being launched by various sections of the society to create awareness about the ill-effects and also provide alternatives. For example, ‘The Brick Clean Group’ launched in Nepal aims to incentivise owners who provide good working conditions to their workers. NGO Coalitions such as, ‘BloodBricks’ also campaign against the situation of workers in brick kilns (The Guardian, 2015).
Options to Deal with Negative Externalities
As discussed above, there has been no formal state intervention regarding the negative externalities created by the brick industry of Nepal. However, there are multiple frameworks created by the ministry in collaboration with the Federation of Nepal Brick Industries. Some of the steps that can be taken to address the problem are:
- Minimum wage policy: The government can standardise the minimum wage policy for the labourers that will ensure that labourers receive their monetary due. Further, the government can create policies to ensure proper working conditions so that the health of the workers is not impacted adversely or at least, the impact is minimised.
- Type of labour: The government needs to create policies such that child labour is banned. Further, the use of bonded labour and forced labour also needs to be looked into. The implementation of this policy is more important as despite the policy, factory owners will be tempted to hire cheaper labour illegally.
- Provide Incentive to alternative industry: With changing technologies, already brick making factories are coming in place that make bricks using machines and not by hands. This automatically provides healthier working conditions and even ensures reasonable wages. These bricks are a little more expensive as compared to the handmade bricks but a much cleaner option. The government can provide subsidies or other incentives to these industries so as to encourage proliferation and discourage handmade brick industry.
- Tax on factory owners: A Pigouvian tax can be slapped on factory owners who are polluting the environment through production of bricks leading to particulate emission, reducing soil fertility and also causing air and water pollution. This revenue can be used to nullify the damage caused and even for welfare of labourers.
Identification of Market Structure
A market involves creation of a mechanism whereby buyers and sellers can meet for the purpose of exchange. Earlier, market used to be a physical place only but in today’s world, it can refer to a virtual place also. A successful market is one in which resources are utilized in the best possible manner. In other words, it is Pareto optimal (Smith, 1776).
The four main type of market structures are:
- Perfect Competition: It is a market structure where the number of firms is large and the size of each firm is relatively small. The firms produce a product which is homogenous in nature, that is, exactly the same. None of the firms can influence the market prices and hence are dictated by the same price. The output is at the maximum. Typically, the barriers to entry and exit are low.
- Monopolistic Competition: It is a market structure where the number of firms is large and the size of each firm is relatively small. However, the firms produce a product which is slightly differentiated in nature, that is, consumers have a choice of products and they may prefer one firm over the other. Hence, the firms can influence the market prices to some extent.
- Oligopoly: It is a market structure where the number of firms is small, leading to competition among firms. The firms may also collaborate with each other to control prices and maximize profits by controlling product supply.
- Monopoly: It is a market structure where there is a single firm and hence, no competition. This creates dominance of the single firm and complete control over the market prices. Typically, the barriers to entry and exit are high.
From above discussion, we can identify that the brick kiln industry in Nepal has the closest resemblance to perfect competition market structure. This is because there is large number of small factories that are producing homogenous product, bricks. Further, the price of bricks is same and firms have to follow the same price. The barriers to entry are low as can be seen through sudden splurge in number of factories.
From the above discussion, it is clear that the markets, when left to their own mechanisms are not always successful due to multiple reasons as discussed above. In such situations, a market failure occurs which requires a state intervention to rectify the failure and get the markets back to equilibrium state or at least rectify resource allocation. The market failure can be of various types, such as externalities, public goods, information asymmetry etc. The state intervention can take multiple forms such as taxes or regulations or subsidies etc.
However, the state intervention does not guarantee rectification of market failure as there are pros and cons of the intervention. Sometimes, it may be successful if implemented well and accepted well. While other times, it may be unsuccessful due to host of factors as discussed above. However, in most cases, if right steps are taken at the right time, state intervention is most likely successful.
We also discussed a case study for negative externality in Nepal where the brick industry is casing air pollution, water pollution and health damage. However, there has been no state intervention till date even when a policy framework has been created by the ministry. Hence, some intervention is required to control the market failure where society is being adversely impacted at the cost of factory owners’ profits from the brick factory. Some of the possible options for intervention were also discussed, such as an environment tax on factory owners, minimum wage policy, and minimum working conditions for labourers and using revenue for controlling environmental damage and labour welfare. It was also seen that the industry bears the closest resemblance to perfect competition market stricture.