WHAT ARE EXTERNALITIES?
Externalities are common in virtually every area of economic activity.
They are defined as third party (or spill-over) effects arising from the
production and/or consumption of goods and services for which no
appropriate compensation is paid.
Externalities can cause market failure if the price mechanism does not
take into account the full social costs and social benefits of production
and consumption.
The study of externalities by economists has become extensive in recent
years - not least because of concerns about the link between the economy
and the environment.
PRIVATE AND SOCIAL COSTS
Externalities create a divergence between the private and social costs of
production.
Social cost includes all the costs of production of the output of a
particular good or service. We include the third party (external) costs
arising, for example, from pollution of the atmosphere.
SOCIAL COST = PRIVATE COST + EXTERNALITY
For example: - a chemical factory emits wastage as a by-product into
nearby rivers and into the atmosphere. This creates negative externalities
which impose higher social costs on other firms and consumers. e.g.
clean up costs and health costs.
Another example of higher social costs comes from the problems caused
by traffic congestion in towns, cities and on major roads and motor ways.
It is important to note though that the manufacture, purchase and use of
private cars can also generate external benefits to society. This why
cost-benefit analysis can be useful in measuring and putting some
monetary value on both the social costs and benefits of production.
1
MARKET FAILURE AND EXTERNALITIES
When negative production externalities exist, marginal social cost >
private marginal cost. This is shown in the diagram below where the
marginal social cost of production exceeds the private costs faced only by
the producer/supplier of the product. In our example a supplier of
fertiliser to the agricultural industry creates some external costs to the
environment arising from their production process.
2
WHY DO EXTERNALITIES LEAD TO MARKET FAILURE?
If we assume that the producer is interested in maximising profits - then
they will only take into account the private costs and private benefits
arising from their supply of the product. We can see from the diagram
below that the profit-maximising level of output is at Q1. However the
socially efficient level of production would consider the external costs
too. The social optimum output level is lower at Q2.
3
This leads to the private optimum output being greater than the social
optimum level of production. The producer creating the externality does
not take the effects of externalities into their own calculations. We
assume that producers are only concerned with their own self interest.
In the diagram above, the private optimum output is when where private
marginal benefit = private marginal cost, giving an output of Q1. For
society as a whole though the social optimum is where social marginal
benefit = social marginal cost at output Q2.The failure to take into
account the negative externality effects is an example of market failure.
NEGATIVE CONSUMPTION EXTERNALITIES
Consumers can create externalities when they purchase and consume
goods and services.
o Pollution from cars and motorbikes
o Litter on streets and in public places
o Noise pollution from using car stereos or ghetto-blasters
o Negative externalities created by smoking and alcohol abuse
o Externalities created through the mis-treatment of animals
o Vandalism of public property
o Negative externalities arising from crime
In these situations the marginal social benefit of consumption will be
less than the marginal private benefit of consumption. (i.e. SMB <
PMB) This leads to the good or service being over-consumed relative to
the social optimum. Without government intervention the good or service
will be under-priced and the negative externalities will not be taken into
account. Again there will be a deadweight loss of economic welfare.
4
In the example shown in the chart above we illustrate the potentially
negative effects of prople consuming cigarettes on other consumers. The
disutility (dis-satisfaction) created leads to a reduction in the overall
social benefit of consumption. If the cigarette consumer only considers
their own private costs and benefits, then there will be over-consumption
of the product. Ideally, the socially efficient level of cigarette
consumption will be lower (Q2). The issue is really which
5
policies/strategies are most appropriate in reducing the total level of
cigarette consumption!
CORRECTING FOR EXTERNALITIES – GOVERNMENT
POLICIES.
Individuals who consider only their own private costs and private
benefits will do too much of any activity that generates negative
externalities, and too little of one that generates positive externalities.
When an activity generates both positive and negative externalities,
private and social welfare will coincide only in the unlikely event that
these opposing effects happen to offset one this exactly.
When externalities are present the individual pursuit of self interest
rarely results in maximum social welfare. When it does not, we have an
outcome that is, by definition, inefficient. This, in turn, means that it is
possible to rearrange things in a way that makes at least some people
better off without harming others in the process. There is an economic
rationale for some form of government intervention in markets where
externalities are prevalent.
How can we take into account the third party effects that necessarily
arise? The key is to internalise the externalities that exist - i.e. make the
firms and consumer that create the externalities take them into account
when making their decisions
POLLUTION TAXES
The classic way to adjust for externalities is to tax those who create
negative externalities. This is sometimes known as making the polluter
pay or introducing Pigouvian Taxes.
Problems with environmental taxes
If taxation is too high, in part a result of the problem of assigning
accurate monetary values to the external costs created by producers and
consumers, the result can be the expansion of grey markets where
producers and consumers try to avoid the taxes.
6
One of the effects of the Landfill Tax over the last four years has been an
explosion in "fly-tipping" as producers seek to avoid paying the tax.
Taxation may not be directed correctly if it is hard to pinpoint precisely
who is causing the pollution - such is the case along rivers where several
industrial plants might be emitting effluents. Should producers be subject
to a consistent tax regime when some are more at risk of polluting than
others?
Producers may be able to pass on the burden of the tax to the consumers
if the demand for the good is inelastic or the supply of the product is
elastic.
Higher taxes may cause cost-push inflation which itself may have
detrimental effects on the economy - affecting those people who have had
nothing to do with the pollution itself.
A further problem with using taxes to control externalities is that some
taxes have a regressive effect on people on low incomes. Good examples
to use would be the increased real level of duty on cigarettes and alcohol
and the impact this has on households on below average incomes.
Examples of "green taxation" introduced into the UK in recent years
includes the increased real level of excise duty on cigarettes and alcohol;
the landfill tax and substantial increases in the real value of duties on
petrol.
The government has also announced the introduction of the climate
change levy - a controversial decision described in one article as
"manufacturing industry's version of the poll tax"
POLLUTION REGULATION
Examples include:
• Setting minimum standards for health and safety at the workplace
• Stricter penalties for firms and consumers who break regulations
• Banning cigarette advertising and making workplaces no-smoking
environments
7
THE COASE THEOREM
An alternative to pollution taxes and government regulation is for the
polluters and those affected to come to a bargaining solution where the
latter are compensated.
Ronald Coase, from the University of Chicago, was the first to see that if
property rights are fully assigned and if people can negotiate at low cost
with one another they will arrive at efficient solutions to problems caused
by externalities without the need for explicit government intervention in
the form of regulation and/or taxation.
This insight is called the Coase Theorem, and on the strength of it Coase
was awarded the Nobel Prize in Economics in 1991.
8
WHAT ARE POSITIVE EXTERNALITIES?
Positive externalities exist when the marginal social benefit of
production and or consumption exceeds the marginal private benefit i.e.
production and/or consumption generate external benefits that may go
under-valued by the market
There are plenty of examples of economic activities that can generate
positive externalities:
Industrial training by firms: This can reduce the costs faced by other
firms and has important effects on labour productivity. A faster growth of
productivity allows more output to be produced from a given amount of
resources and helps improve living standards throughout the economy.
See the revision notes on the production possibility frontier
Research into new technologies which can then be disseminated for use
by other producers. These technology spill-over effects help to reduce the
costs of other producers and cost savings might be passed onto consumers
through lower prices
Education: A well educated labour force can increase efficiency and
produce other important social benefits. Increasingly policy-makers are
coming to realise the increased returns that might be exploited from
investment in human capital at all ages.
Health provision: Improved health provision and health care reduces
absenteeism and creates a better quality of life and higher living
standards.
Employment creation by new small firms
Flood protection system and spending on improved fire protection in
schools and public arenas
9
Arts and sporting participation and enjoyment derived from historic
buildings
POSITIVE EXTERNALITIES AND MARKET FAILURE
Why do positive externalities lead to a failure of the normal free-market
mechanism?
Where substantial positive externalities exist, the good or service may be
under consumed or under provided since the free market may fail to
take into account their effects. This is because the marginal social
10
benefits of consuming the good > private marginal benefits. In the case
of external benefits from production, the marginal social cost would be
< private marginal costs.
Consider the example of health care. Good quality health care brings
positive spillover effects both for the recipient of the care but also their
families and associates. A well functioning health care system also
reduces the scale of absenteeism from work due to sickness and illness.
We see in the diagram above how the provision and consumption of
health care services leads to an increase in social benefits and a reduction
in social costs. As a society we should be encouraging people to increase
their consumption of health care services.
Positive externalities from technological spill-overs
In the diagram below we assume there has been a positive externality in
production in the form of a technology spillover. The use of new
technology has brought down costs to other producers - social cost lies
below private cost and output of the product (i.e. a new robot or piece of
software) should be encouraged towards output Qb rather than the private
optimum Qa. This might be achieved through the use of a producer
subsidy that reduces the cost of production / consumption and encourages
an expansion of supply in the market.
11
12
GOVERNMENT FAILURE.
What is Government Failure?
Some economists believe that even with good intentions governments
seldom get their policy application correct. They can tax, control and
regulate but the eventual outcome will be a deepening of the market
failure or even worse a new failure may arise.
Possible Causes of Government Failure
(1) The pursuit of self-interest amongst both politicians and civil
servants rather than operating on behalf of citizens which leads to a
misallocation of resources (for example decisions about where to build
new roads, by-passes, schools and hospitals, inappropriate tariffs and
other forms of import control and also decisions as to which industries
and markets to offer government subsidies)
(2) Electoral pressures leading to inappropriate government spending
and tax decisions - e.g. boosting state welfare spending in the run up to an
election, or decisions to bring forward major items of government capital
spending on infrastructural projects ahead of an election without the
projects being subjected to a full and proper cost-benefit analysis
(3) A tendency to look for short term solutions to economic problems
rather than making considered analysis of long term considerations
(examples might include important decisions about transport policy or
extra funding for the National Health Service). The risk is that myopic
decision-making will only provide short term relief to particular problems
but does little to address structural problems. A decision for example to
build more roads might simply add to the problems of traffic congestion
in the long run. Short term subsidies to the steel industry or coal
producers to keep open loss-making steel plants and coal pits might
eventually prove to be a waste of scarce resources if the industries
concerned have little realistic prospect of achieving an economic rate of
return in the long run.
(4) Regulatory capture. This is when the industries under the control of
a regulatory body begin to move policy options so as their outcome is in
their favour. Some economists argue that regulators can prevent the
ability of the market to operate freely. We might find examples of this in
agriculture, telecommunications and the other utilities and also in
environmental protection.
13
(5) Disincentive effects created by measures designed to reduce income
inequalities (including the poverty trap) or the loss of business
competitiveness caused by the introduction of the National Minimum
Wage or the Working Families Tax Credit – thousands of small &
medium sized enterprises have faced higher costs because of the
increasing levels of red tape brought about by new government
regulations.
Equally a decision by the government to raise taxes on de-merit goods
(such as cigarettes) might lead to an increase in tax evasion, smuggling
and the development of grey markets where trade takes place between
consumers and suppliers without paying tax. Equally a decision to
legalize and then tax some drugs might lead to a rapid expansion of the
supply of drugs and a substantial loss of social welfare arising from over
consumption.
(6) The Environmental impact of government price support for farmers
(including the long term impact of exemptions from taxation for farmers
selling land to developers, the externalities arising from increasing use of
subsidized fertilizers, and the long running issue of structural excess
supply arising from guaranteed intervention prices for farmers within the
CAP)
(7) Imperfect information - How does the government establish what
citizens want it to do? Our electoral system is not an ideal way to
discover this! Proponents of government failure argue that the free market
mechanism is the best way of finding out (a) what consumer preferences
are and (b) aggregating these preferences based on the number of people
that are willing and able to pay for particular goods and services
14
THE UK LANDFILL TAX.
The Landfill Tax was introduced in October 1996 and is levied on waste
deposited in landfills. The objectives of the tax are to
• encourage waste producers to minimise the volume of waste
generated
• reduce the amount deposited in landfills
• encourage recycling
Landfill operators are liable for the tax on all consignments of wastes
accepted for landfill disposal.
A distinction is made between inactive waste, which is taxed at £2 per
tonne, and other waste at the standard rate of £10 per tonne.
In the March 1999 budget, the Chancellor announced that the standard
rate will be subject to a landfill tax escalator of £1 per tonne per year for
at least another five years, reaching £15 per tonne in 2004. This is
designed to increase the incentive to re-cycle or incinerate waste (see
below)
Exemptions to the Landfill Tax
A number of categories of waste are exempt from taxation. These are:
• dredgings from inland waterways and harbours
• naturally-occurring minerals from mines and quarries
• domestic pets, buried in pets' cemeteries
• wastes from the remediation of historically contaminated land if
the purpose of the remediation is development, conservation or the
provision of amenity, or to remove the potential harm from
pollutants
Areas at landfill sites where waste is sorted, recycled or incinerated may
be designated tax-free areas
Landfill Accounts for around 90% of controlled waste in the UK. 90 -
100 million tonnes of waste are sent to landfill each year. The trend is
towards fewer but much larger landfill sites in UK.
Landfill is regarded as the only option for some inert wastes and for
wastes that are difficult to burn or recycle.
15
Social Costs of Landfill
Landfills can release chemicals into surface & underground water, and
soil, and to generate methane, which is a ‘greenhouse gas’. The noise
from increased traffic of heavy lorries also creates external costs as does
the odour and visual dis-amenity. There is also the risk of contamination
of land and surrounding water.
The Landfill Tax has had mixed results. One consequence has been a
rapid rise of illegal fly-tipping - i.e. the dumping of waste on private land.
There is some evidence of fraud and the tax revenue from the tax is not
being used to find recycling. Most of burden of the tax falls on local
councils
16
PROPERTY RIGHTS AND MARKETABLE POLLUTION
PERMITS.
Some economists believe that a tax-subsidy solution to externalities
rarely works effectively and without distortions to the way a market
operates. They believe that the free market mechanism offers a better
solution.
If property rights exist for producers and other owners of factors of
production, these rights can be bought and sold to reflect the value of
externality effects created.
Pollution permits are a combination of command and control and
market-based approaches to the task of limiting pollution emissions.
Polluters can bid for a permit that allows them to create a fixed amount
of pollution. These permits can be resold: The government can gradually
reduce the number (volume) of pollution permits available so that total
pollution emissions can be controlled.
• If you can sell a permit for more than it is worth to you -- you do so
• If you can buy a permit for less than it is worth to you -- you do so
If a company (X) has a high marginal benefit from pollution emissions –
it will be willing to buy some permits from another business (Y) who has
a lower marginal benefit from emitting pollution.
Assume initially that both firms X and Y are producing 20 units of a
pollutant each from their output. The government may decide that only
eighteen units of pollution is permissible for each firm. If firm X manages
17
to reduce pollution emissions to sixteen units it would be a given a credit
of 2 units.
This permit could be traded with firm Y – allowing Y to continue
producing twenty units of the pollutant. The effect is that total pollution
emissions still falls to thirty six units (for the two firms combined) - but
the systems of traded permits means that pollution reduction is
concentrated in the firms where pollution abatement can be achieved at
the lowest cost.
The market for permits will reach a market-clearing price where the
marginal benefit of pollution emissions is equal. Businesses can either
buy permits or invest in technology to reduce pollution emissions -
whichever approach saves them money. Gradually the total amount of
pollution allowed can be reduced – as the stringency of pollution limits is
tightened, so the value of permits may rise, they will be more valuable to
companies that can bring down pollution levels at lowest marginal cost.
Marketable permits have been tried in several countries – including
Singapore where an auction mechanism has been introduced for the
trading of ozone-depleting substances. For the system to be effective
there needs to be common acceptance of the legal framework for the
trading of permits and regulation of the amount of pollution produced.
The Kyoto Summit on Climate Change (held in December 1997)
witnessed a decisive move towards a greater use of internationally
traded pollution permits – based on the idea that each country is
required to achieve a specific percentage reduction in pollutants such as
C02.
Potential problems with traded pollution permits:
• How are permitted levels of pollution decided? If based on current
production levels they may be no advantage for firms that have
already taken steps to control their pollution emissions
• Traded permits may see pollution being concentrated in certain
geographical areas. At the Kyoto Summit, developing countries
were not required to make reductions in pollution – but could be
given credits for “certified reductions” in pollution that could be
then traded with other countries. This might allow countries such
as the United States to buy up pollution permits from LDCs
(including many form high polluting countries in Eastern Europe) –
and avoid the need to reduce pollution themselves
18
• There are likely to be high administrative costs associated with
monitoring pollution emissions – particularly if the number of
firms involved is very large.
19
