Negative Externalities

• Externalities


  They occur when the actions of consumers or producers give rise to negative or positive side effects on third parties that are not part of these actions and whose interests are not taken into consideration.
• Negative Production Externalities


  These occur when the production of a good creates external costs that are damaging to third parties. There is a production externality because over and above the firm's private costs of production (MPC), there are additional costs that spill over onto society.
• Correcting Negative Production Externalities: Taxes


  Some governments may choose to impose a per unit tax on the product, or a tax per unit of pollutants emitted which causes the supply curve to shift left.
• Optimal Tax Policy


  To impose a tax that is exactly the equal to the external cost so that the MPC overlaps with the MSC.
• Advantages of Taxes


  -It eliminates or reduces the size of the externality.

  -It acts as an incentive for producers to switch production methods.

  -It reduces the output towards Qopt.

  -It internalizes the externality by forcing consumers and producers to pay more.
• Disadvantages of Taxes


  -It is difficult to asses the magnitude of the externality. (The value of the harm)

  -Determining the appropriate amount of tax is a challenge.

  -Taxing the good may not stop pollution, only reduce it.
• Correcting Negative Production Externalities: Tradable Permits

  Firms are issued with emission permits in proportion to their levels of pollution. Firms that can reduce pollution at a low cost may sell their spare pollution permits to other generators who have a high cost of reducing pollution. Thus, a market in tradable permits is created stimulating the reduction of pollution through the possibility of making money.
• Tradable Permits: Advantages


  -Firms are given a profit incentive to reduce the externality.

  -Consumers may benefit from the sale of the permits to other companies in the form of lower prices.
• Tradable Permits: Disadvantages


  -This doesn't stop companies from polluting, it only gives them an incentive to do so.

  -Where a degree of monopoly power and inelastic demand exist, the cost of purchasing permits may be passed on the consumer in the form of higher prices.
• Correcting Negative Production Externalities: Government Regulation


  Governments may choose to create laws to deter the production of the good. Such as banning companies from dumping waste, forcing cleaner production with improved technology, limiting emission levels and ordering firms to reduce the amount of goods they produce.
• Government Regulation: Advantages


  -It can totally eliminate the externality through bans

  -Reduces the size of the externality

  -Reduces the output towards Qopt.
• Government Regulation: Disdvantages


  -Assessing the magnitude of the externality is difficult.

  -The govt. must create an agency to monitor/enforce the regulations which is costly and time consuming.

  -Disputes between the govt. and the firms can result in extra costs in legal expenses.
• Negative Consumption Externalities


  Refers to the external costs created by the consumers during the course of using the product or service.
• Correcting Negative Consumption Externalities: Govt. Regulation


  The govt. may choose to create laws in order to deter the consumption of goods such as increasing the legal drinking age, banning the use of mobiles while driving, heavily regulating drugs etc.
• Govt. Regulation Disadvantages for Consumption

  -Assessing the value of external costs is very difficult.

  -Banning goods may lead to the creation of a parallel market since many demerit goods are inelastic and addictive.
• Correcting Negative Consumption Externalities: Advertising

  The govt may choose to persuade consumers to change their behaviour through advertising campaigns that encourage them to stop consuming the product or switch to another product.
• Advertising Advantages


  -Easy to implement

  -Reduces the size of the externality

  -Reduces output towards Qopt.
• Advertising Disadvantages


  -Funding ad campaigns will mean that the govt. will have to spend less money on something else (Opp Cost)

  -No guarantee that the ad campaign will be successful given the addictive and inelastic nature of demerit goods.
• Correcting Negative Consumption Externalities:

  Taxes


  The govt. may want to impose indirect (excise) tax on the good. The tax will remove the overproduction and lead to allocative efficiency by internalizing the externality by creating incentives for consumers to change their consumption patterns.
• Taxes Advantages for Consumption

  -It raises additional tax revenue for the govt.

  -It reduces the size of the externality.

  -Reduces output towards Qopt.
• Taxes Disadvantages for Consumption

  -Measuring the value of the external costs is difficult.

  -Taxing inelastic goods would not be very effective.