Assessment 2 (Research Essay) -
This is assessment 2: Research Essay 30 marks
Length 3,000 words
Please note that this question requires substantial research (see the assessment criteria below).
a) Explain what negative externalities are, and why there may be a case for government intervention to address them. Describe how taxes/charges and regulation can be used to correct the negative externalities and the pros and cons of each method. Provide real life examples. (6 marks)
(b) Choose a case study from your home country where an externality exists in a current market. Using your case study (real data) explain the effect of externality on market outcomes including dead-weight loss and discuss ways that your government has addressed the presence of negative externalities in the market. (10 marks)
(c) Suggest other options for dealing with negative externalities in your case study. (6 marks)
(d) Using the key characteristics of the market structures identify the market structure in your case study. (6 marks)
Additional marks (2 marks)
Appropriate use of referencing. 2 marks
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:
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.
In this case the social cost is created which is ideally equivalent to cost of negative impact of carbon emission by the car.
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):
There are many advantages as well as disadvantages of such Pigouvian taxes:
Main advantages include:
Main disadvantages include:
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.
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:
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:
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.