Abstract welfare loss, indicated by the difference between


One of the hardest tasks for any
economist is to measure the impact of negative externalities and how they can
cause market failure. Externalities, particularly negative ones, are formed
from inefficiencies created through production or consumption. These negative
externalities create a market failure because social costs exceed private
costs, creating a loss in social welfare from rising prices on decreased

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Market failure occurs when the
allocation of resources in a market becomes inefficient. This inefficiency
leads to the market not being perfectly competitive, because of a variety of
economic situations including negative or positive externalities.

For the purposes of this paper, an
examination will be conducted on how negative externalities – effects on third
parties originating from the consumption or production of a good – cause market
failures. There are two types of negative externalities – consumption and production
– which can be analysed.


Production Externalities

The first way to analyse these
externalities is through production and how they contribute to market failure.
Production externalities impose external costs on the third party – those
outside of the market – and no compensation is paid for the increase (CORE ECON,
2014). Some examples of negative production externalities include air pollution
from factories, the external costs from farming pesticides and fertilizer,
along with the damage that is caused to the environment from industrial fishing
expeditions (Garcia 2017). Negative externalities cause social costs to exceed
private costs, driving the equilibrium quantity of output down. The equilibrium
level of output then falls because it is clearly inefficient in its allocation.
With a higher supply from the market output, the quantity produced falls, and
sees a subsequent rise in price. The fall in output and rise in price creates a
social welfare loss, indicated by the difference between the marginal social
cost and the marginal private cost. The market output that is supplied is
higher than the social optimum, creating losses for the producer as well as the

However, there are several ways that
have been proven to be successful in combating these production externalities.
One of the forms of this is to create a pollution tax, which is employed
worldwide. Some examples include the carbon tax in British Columbia, smoking
taxes in China, emissions trading schemes in the EU, and a proposed charge for
traffic congestion in India (Medema 2017). The idea is that the costs of the
pollution are redirected from the third party back on to the source of the
polluter, in other words “making the polluter pay” the cost (Ajefu 2015).
Subsequently, the tax increases the aforementioned private cost of consumption
or production, which creates a fall in demand or output (Selvaraj 2014).


A practical application of stopping
production externalities can also be seen through the EU Carbon Emissions
trading scheme. Using an economic tool known as “cap-and-trade,” the program is
designed to limit the emissions of harmful greenhouse gases, particularly
carbon dioxide (Gersbach 2017). The legislation states a specific decreasing
cap for carbon dioxide emissions from energy intensive sectors, and allows for
the auctioneering or allocation of emissions allowances (Medema 2017). These
allowances are often traded on the open market, allowing for an influx which
ultimately increases social welfare (Ajefu 2015).


The idea is that businesses will be
encouraged to buy enough emissions allowances such that the higher the price,
the more of an incentive they will have to cut pollution (Selvaraj 2014).
Utilizing the numbers relevant to the actual institution of the scheme, many
experts believe that a carbon allowance price of at least 30 euros per tonne is
needed to drive investment in technologies that can lower emissions in the
future (Gersbach 2017). As of right now, the excess supply of emissions
allowance permits has collapsed the price of each allowance to below 10 euros
per tonne (Gersbach 2017).

There are several arguments for price
mechanisms which can be used to manipulate and reverse the negative effects of
externalities. To summarize, the arguments for price mechanisms suggest that
they make the risks and costs of investing in harmful projects less attractive.
Furthermore, it subsequently creates a stabilized market for eco-friendly
materials such as carbon. By making these elements more attractive, it drives
demand away from polluters.


Consumption Externalities

order to analyse consumption externalities and how they create market failures,
it is important to first analyse what creates these scenarios – demerit goods.
Demerit goods are classified as goods or services whose consumption is
considered socially damaging because of the negative effects that are inflicted
on the consumer (CORE ECON, 2014). Economists posit that if left unregulated
and up to market forces, these goods would be over-consumed (Medema 2017). Common examples of these goods include
cigarette smoking, which can lead to passive smoking, and road congestion
(Ajefu 2015).

          In markets where negative consumption
externalities exist, supply is equivalent to the private marginal cost or the
social marginal cost. Private marginal benefits and social marginal benefits
are different for each quantity supplied. The initial price is set at the
equilibrium quantity where social marginal costs are equivalent to private
marginal benefits. The equilibrium quantity falls along with the price, leading
to a lower total benefit from the social marginal benefit curve. The difference
between the private marginal benefit and the social marginal benefit curve is
known as the deadweight welfare loss – in other words, the sum of the penalty
against society because of its consumption.

Economists have previously argued that
the revenue from pollution taxes should be utilized for fiscal allocations to
projects that protect or in some way enhance the environment (Ajefu 2015). Economists
have colloquially termed this kind of measure as a corrective tax to realign
the deadweight loss to the initial consumer of the demerit good (Selvaraj 2014).
An indication of how this would work can be seen through New Delhi’s suggested
congestion charge (Gersbach 2017). The plan is to use the money raised from the
tax to be allocated towards improving transport services so as to improve
efficiency from each of the vehicles that pollute the environment (Medema 2017).
Another example of how production externalities can be reduced is through the tax
on cigarettes, whose revenue can be used to fund health care programs to
stopping future use.

Regulations such as this can extend from
market failures into government failures. The first issue with pollution taxes
is determining the right level of taxation to make a fair and economically
responsible tax (Garcia 2017). Without the correct social cost will align
equally with the social cost, you can overcorrect and under-correct the problem
(Ajefu 2015). The second issue with pollution taxes is the effects on consumer
welfare. It would be economically foolish to think that producers would accept
a tax that is input on them because of their own pollution (Medema 2017).
Producers would likely pass on the tax to the consumer, if the demand for the
good is inelastic – or when a good or service is unaffected when the price
changes (Garcia 2017). Demand subsequently minimally reduces, leading to more
market failure. Experts have also studied the effects of such taxes on demerit
goods, and many conclude that taxes may have a regressive effect on
lower-income consumers and lead to a widening of effective income when all is
said and done (Ajefu 2015).

Finally, taxes can have significant
effects on employment and investment. Should pollution taxes be raised in one
country, globalist producers can shift to countries with lower taxes and
similar infrastructure for business. Ultimately, the “social” cost of global
pollution is not resolved, and may create structural unemployment and a loss of
competitiveness internationally. The trade balance would also worsen.



externalities seem simple on the surface in how they can be resolved. To summarize,
there are three main points in the case for regulating negative externalities.
First, it is proposed that regulations act as a spur for business innovation,
encouraging businesses for example to cut their total carbon emission levels.
In reality, these regulations can lead to undesired outcomes, and even create
government failures. Many experts also argue that regulations may be more
effective is demand is unresponsive to price changes, but in reality, creates
an environment where businesses actually contribute to an even greater market
failure because they align the tax onto the consumer, creating an even larger
gap between social and private benefit or cost. Finally, it has often been
proposed that regulations could be built up progressively each year to get
tougher. In theory, it would stimulate capital investment, but would also
create more costs for businesses to meet regulations, discouraging smaller
businesses and harming competition.


          Thus, we can conclude a rather simple
yet difficult fallacy – negative externalities are here as long as the
processes, goods and services they come from are here. Hundreds of economists
and countless administrations across the world have tried to solve the problem,
to no avail.