Externalities of an economy activity can cause market failures because the market equilibrium fails to correctly reflect the real costs and benefits of a product or service. The equilibrium price indicates an ideal balance between the cost of production and the benefits derived by the buyers that optimizes the production process (Cherry, Steffen and Stephan 199). Significant externalities affect the equilibrium price by generating incentives that affect the other economic variables leading to market failure. Pollution is one such externality, and going by the fact that it is a negative externality it implies that the manufacturers fail to bear all the costs of production leading to excess production. Positive externalities generate the reverse effect as they decrease the production process because the consumers are not able to get the full benefits of the product.
Pollution is a negative externality in the production process as it negatively affects the welfare of the society. When the producer fails to meet the cost of pollution by passing it to the society it means that such producers will incur lower costs of production thereby resulting into excess production. Factoring in the cost of such externality will lead to a higher cost of production, higher prices for the consumers and consequently lower level of production (Dinan, 70). This generates a more efficient equilibrium than the initial scenario where such costs were not factored in the production process. The effects of such externalities are excess production, wrong pricing because of the higher costs to the consumer and higher levels of pollution. This implies that such goods have a greater cost to the society than what the consumers are paying for them.
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"Welfare Effects of Pollution in a Competitive Market".
A competitive market has an efficient level of output but a negative externality like pollution leads to inefficiency. The inefficiency is caused by the difference between the private marginal cost and the social marginal cost (Rezai, Duncan and Lance 70). The presence of negative externalities means that the private marginal cost is lower than the cost of the product to the society. The reverse is true for positive externalities.
Figure illustrates a case where a firm generates pollution which is a negative externality in a competitive market. The competitive market yields a price of Pc and output of Qc. However, when pollution is factored in, the SMC becomes higher than the PMC for the entire positive points of output. The Social optimal level of output is found at a lower level than the Qc.
When the effects of pollution are accounted for in the production process the optimum level of social output is found at the point where there is no pollution. However, at that level there is no output. An extra output creates benefits to the consumers but it also generates a negative externality that causes social damage. This is why a cost benefit analysis need to be conducted to establish the efficient level of output where marginal benefit of production balances off with the resultant marginal damage (Beghin, Anne‐Célia, and Stéphan 37). This implies that in a competitive market, a negative externality such as pollution generates a large level of output which represents market inefficiency. The producers fail to take responsibility for the external costs and instead pass them to the society (Chen, Zhan-Ming, et al 30). For instance when the production firms pollute the air without meeting the extra cost of pollution, it causes higher medical expenses because of the poor air quality. This can be corrected by implementing measures like taxation to ensure that the producers meet the cost of pollution and produce at the optimum level.
- Beghin, John Christopher, Anne‐Célia Disdier, and Stéphan Marette. “Trade restrictiveness indices in the presence of externalities: An application to non‐tariff measures.” Canadian Journal of Economics/Revue canadienne d’économique 48.4 (2015): 1513-1536.
- Chen, Zhan-Ming, et al. “Environmental externality of coal use in China: Welfare effect and tax regulation.” Applied Energy156 (2015): 16-31.
- Cherry, Todd L., Steffen Kallbekken, and Stephan Kroll. “Accepting market failure: Cultural worldviews and the opposition to corrective environmental policies.” Journal of Environmental Economics and Management 85 (2017): 193-204.
- Dinan, Terry M. “Economic Efficiency Effects of Alternative Policies for Reducing Waste Disposal 1.” The Economics of Residential Solid Waste Management. Routledge, 2017. 65-79.
- Rezai, Armon, Duncan K. Foley, and Lance Taylor. “Global warming and economic externalities.” The Economics of the Global Environment. Springer, Cham, 2016. 447-470.
