Due to the numerous factors involved in a market, it is difficult to always have an ideal market structure for goods and services. Inevitably, certain market will experience market failure, which is when a market is not able to allocate resources in a Pareto-efficient way. To be Pareto-efficient, resources must be allocated in a way that is most efficient and where one party’s situation cannot be improved without making another party’s situation worse. There are many examples of market failure, and one of it is negative externality.
Negative externality is when an economic activity negatively affecting and imposing external costs on unrelated third parties. Negative externality could occur in both the production and the consumption sector. An example of negative externality of consumption is the usage of automobiles. It is very convenient for people to use public transport or their personal cars to travel. However, automobiles emit CO2. CO2 is one of the greenhouse gas that pollutes the environment, and pollution is a form of negative externalities as it affects everyone around the area. A research showed that in 2015, 27% of the Greenhouse Gas Emission in the U.S. was from transportation (EPA, n.d.). It is impossible for the current society to live without automobiles for transport, however there are people who try to reduce the usage of cars or use other forms (such as bicycle or electric cars) to reduce the carbon dioxide emissions. Similarly, negative externality of production also results to market failure as producers are not held responsible for the spill-over cost that may result from the production, such as overfishing. Overfishing can lead to reduced harvest of target fish, catching untargeted or endangered fish, and changes in marine biodiversity (Jetson, 2014). There is a limitation to the number of fish in the sea, thus overfishing will continue to reduce the number of fish in water bodies, affecting the food chains within the marine ecosystem.
Figure 1 is an example of the current usage of vehicles. Negative externalities of consumption cause MPB to be greater than MSB. When consuming a product, a consumer will most likely think about gaining maximum utility for themselves, and not worry about the potential effect on others. Such is the case for usage of vehicles, as the consumer would benefit from having their own cars as it will be convenient for them when traveling. However, usage of cars results in emission of greenhouse gases and non-renewable resources, which cause pollution and other environmental damages that the consumer is not paying for. From figure 1, the maximizing of utility can be seen through the consumer’s consumption at Q1, where MSC = MPB. Q2 would be the desired consumption from a society’s point of view as Q2 is where MSC = MSB, meaning this point is where the social welfare is maximized. However, if consumers continue to consume at Q1, there will be a welfare loss to society, in this case, in the form of greenhouse gases being emitted to the environment. Welfare loss is identified by the area shaded green between Q1 and Q2. This also means market failure exists as the quantity of output at Q1 is greater than the socially optimal level of output which would be Q2.
Figure 2 shows an example of negative externalities in overfishing. Negative externality in production sector MSC to be greater than MPC. Like consumers thinking of maximizing their utility for themselves, producers would also think about maximizing the production, thus not caring/paying for the negative externalities that could result from the production. Figure 1 shows that producing at Q1 would be maximizing their production, where MPC = MPB. For social welfare to be maximized, it would be preferred for firms to be producing at Q2, and at the price of P2, which is the social optimum point. The green shaded triangle in figure 2 shows the welfare loss when negative externalities in the production sector occurs. Negative externality in production sector is also considered a market failure as goods and services are produced at a point higher than the socially optimal level.
Market failure is considered pareto-inefficient, as there are potential room for improvement. Figure 3 shows the diagram of Pareto-inefficiency in transportation methods. Point A would be the current demand for private cars and public transport, as neither are utilized to the max. Both B and C are considered pareto-efficient, but it should be encouraged for the demand for public transport to increase because it produces less negative externalities compared to private cars.
Government can intervene to try to address the market failure created from negative externalities. Taxation, subsidies, and laws and regulations are ways which government could use to reduce negative externalities.
For example, the negative externality of using private automobiles can be addressed using tax, such as implementing/increasing the VED (Vehicle Excise Duty), and subsidy for goods/service that could replace the utility of having a private automobile. As figure 4 shows, the addition/increase of VED on automobiles should reduce the quantity used. This is because consumers will not want to pay higher taxes to use their own vehicles, so they are likely to rely on their next option available, which is to use public transports. Government should subsidise public transport to increase the incentive for people to utilize the public transport rather than their own cars. The short-run focus should be on reducing private car usage, ease consumer into using public transports, and make public transports more accessible throughout the city/country. However, in long-term, the government should discourage and ban the use of vehicles that run on gasoline or diesel, while subsidizing on the development on eco-friendly automobiles.
On negative externalities for production, government could put tax, such as taxing the CO2 emissions from factories. For the overfishing scenario, putting laws and regulation such as putting quota on the number of fish that is being allowed to catch.
As shown in figure 5, the government should put a quota where MSB = MSC, since that is where the socially desirable level of output (Q + Quota) is.
Taxes, subsidies, and legal regulations may work to reduce negative externalities, but these does not work on every scenario, and carry several disadvantages that must be taken note of before choosing which ones to use.
Taxing provide the incentive for both consumers and producers to be efficient, as they would be finding ways to continue to maximize the consumption/production of goods/services while paying the least tax. In addition, taxes raise government revenues which can be used for other government activities such as subsidizing goods/services that have positive externalities. However, it is difficult to determine the price for negative externality. Furthermore, if the demand for a product is inelastic, higher tax would not significantly reduce the quantity demanded. Government must also decide who the tax is targeted for; e.g. should government tax car manufacturers to reduce the quantity of cars bought, or should the government tax the consumers with cars though VED to reduce their incentive to use their private cars?
Subsidies can be advantageous as the price is driven down so products are purchased at socially efficient price, and in long term, change the consumer preference. For example, subsidizing public transport could potentially lead to the consumers preferring to use public transport over their private automobiles. However, government must generate fund for subsidies and determine the amount of subsidy that should be given. Taxing goods with negative externalities is the most efficient way to generate funds for subsidies, but other tax such as income tax could potentially reduce the incentive to work. Moreover, subsidies may lead to firms growing a dependence on government subsidies rather than finding ways to be efficient in their production. Lastly, if a good is inelastic, subsidizing the production of that good would not result in significant increase of demand.
Laws and regulations can be used to ban a good where necessary, and it is clear what the expectations of the government is regarding the production/consumption of the product. However, it is hard to ban many of the product that leads to negative externalities, and include multiple consequences that would follow. Banning cars will reduce pollution but the society becomes inefficient and car manufacturers will become unemployed. It is also not effective if the legal restrictions are not adopted by many countries. For example, if one country put quota on their fishing, but other countries do not, that one country is at a disadvantage and their legal restriction will have no impact in reducing negative externalities.
Market failure occurs due to an inefficient allocation of resources, and an example that leads to market failure is negative externalities. Negative externalities can come from both the production and consumption of goods/services. There are ways in which government can intervene to reduce negative externalities, such as taxation, subsidies, and legal regulations, but if not used in right situations, the intervention can lead to a government failure and not have any impact on reducing the intended negative externalities.