externalities are a form of market failure and the welfare losses that can
result from it and how government can intervene to address the market failure.
Within this essay I shall investigate
how negative externalities produced by the consumption and production of
demerit goods inflict an economic cost upon a third party. The production of harmful
carbon emissions and the consumption of demerit goods shall be used as an
example to highlight how government can intervene to reduce the associated
Negative externalities are the
effect of an economic decision, production or consumption, inflicted upon a
person, or people, “that is not specified as a benefit or liability in a
contract.” (The CORE project, 2017) The production of pollutants resulting from
the burning of fossil fuels produces negative external costs on societies,
including pollution and environmental degradation due to carbon dioxide
emissions. This is deemed socially undesirable as there is an external cost
being forced upon society. This externality results in the marginal social cost
(“the cost of producing an additional unit of a good, considering both the cost
for the producer and the costs incurred by others affected by the good’s
production” ( The CORE project, 2017) varying from the socially optimum point,
which is equal to the marginal private cost (“The cost for the producer of
producing an additional unit of a good, not considering any costs its
production imposes on others.” (The CORE project, 2017)) In this case a
negative externality of production is incurred (as shown below in Figure 1).
1- The Negative Externality Produced due to the Consumption of Fossil Fuels
The negative externality produces
a deadweight welfare loss, shown by the blue triangle in figure 1. In a free
market, without government intervention, the output is at Q1 where
the marginal private cost is equal to the marginal private benefit. However,
the socially efficient allocation lies at Q2, where the marginal
social cost is equal to the marginal social benefit and a higher price of P2
is charged. This results in a negative consumption externality wherein there is
an overproduction of demerit goods. The negative production externality
highlights the welfare gain which stems from reducing the output from Q1
to the socially efficient Q2.
In this case the producer is
making a decision to use fossil fuels as a means of energy supply, which
inevitably results in air pollution, which effects people outside of the market
transaction. Whilst there is a private benefit this is much greater than the
external cost meaning that there is a misallocation of resources, there is an
overuse of fossil fuels, causing a negative externality of production due to
environmental spill over.
Deadweight Welfare Loss
2- The Negative Externality Produced due to the Consumption of Alcohol
Moreover, a negative
externality of consumption may also be incurred by the over consumption of
demerit goods such as alcohol, cigarettes, junk food and gambling. The over consumption
of these goods results in costs to people outside of the market transaction. Using
alcohol as an example these costs include treating illnesses for alcohol
consumption, police efforts dealing with drunken behaviour and car crashes
involving drunk drivers. The negative consumption externality is shown in figure
In the case of a negative consumption
externality, in a free market, sin government intervention, output lies at Q,
exceeding the socially optimum level of Qopt where the marginal
social cost is equal to the marginal social cost. Here the negative externality
is the difference between the marginal social benefit and the marginal private benefit,
therefore it can be said that there is an overconsumption of the good.
In order to “internalise” the
negative consumption externality from the consumption of alcohol, or the consumption
of fossil fuels, government must aim to reduce demand to the marginal socially
optimum. One method of doing so is to introduce a minimum price level of alcohol,
a method that was planned by Scotland in 2015 where a minimum unit price of 50p.
The main purpose of a price floor is to dissuade consumption.
3- The Market for Energy (produced via fossil fuels) Following the
Introduction of a Price Floor
The introduction of a price floor
is vital in discouraging the use of fossil fuels as a means to supplying
energy. By increasing the minimum price of carbon emissions to €30 per tonne,
green and renewable sources of energy such as solar and wind become more
competitive, thus reducing the negative externality (figure 1). The price floor
will also generate a producer surplus (figure 3) as consumers drop out of the
market due to the increased price. However, those which are not priced out of
the market will are instead forced to pay higher prices, as the producers aim
to shift the impact of the price floor onto consumers.
The price floor would lead to the
loss of both consumer and producer surplus as producers are forced to sell at
an increased price to a lesser demand and producers are forced to either buy at
an increased price or drop out of the market. The loss of consumer and producer
surplus at Q2 will produce a deadweight loss (figure 3).
The price floor will also help to
tackle the negative consumption externalities produced by the consumption of
fossil fuels. However, the burning and consumption of fossil fuels is
relatively price inelastic and it is not likely that a large proportion of the
market will be priced out. Therefore, it is unlikely that a price floor could
move the quantity of fossil fuels used from Q1 at the market price of P1 to Q2,
the optimum quantity for society, where there is no deadweight welfare loss and
there is allocative efficiency at a price of P2.
Therefore, in the short term it
is unlikely that the introduction of a price floor will be effective. This is
because consumers will not drop out of the market until a suitable replacement
is found, and so producers will benefit from the increased price of carbon and
will receive greater revenue of €30 per unit.
Since the energy produced by
these fossil fuels will be used in a variety of products the impact of the
price floor will be increased. Manufacturers of transport vehicles will be
encouraged to find alternative methods in which to power their products to
become more cost effective and competitive.
In the short-term consumers will
have to suffer from an increased price of €30 per tonne of carbon or will be
forced to switch to an alternative source of energy. Consumers will have to pay
both a higher price and will have less quantity to demand of Q2, figure 1. However,
in the long term the consumers and society will have a lowered negative
externality produced from the burning of fossil fuels.
Moreover, producers which use
fossil fuels to create energy will also be worse off as they are forced to
produce their good to a smaller demand and will have an excess of supply.
Producers must also pay the €30 per tonne of carbon tax which will result in a
fall in revenue.
The government is the only
stakeholder which will undoubtedly gain from the introduction of a price floor
on the carbon tax of €30 per tonne of carbon. The government will gain revenue
equal to that which the firm will lose, increasing the government budget.
For the price floor to be
effective the minimum price must be set above the equilibrium price. The 30
euro per tonne minimum price is likely to be effective in reducing consumption
of Carbon, as long as the price elasticity of demand for Carbon emissions is
relatively elastic. Given that the change in price is to be relatively large, demand
should be expected to decrease.
Whilst government may use market
based policies such as a price floor or taxation, they may also apply
government regulations such as tradable permits. These are pollution rights
issued to firms and cap the level of pollution from economic activities. Government
may increase the price of such caps to increase the opportunity cost to firms
that pollute excessively, whilst the funds raised may be reinvested as government
spending to further reduce the effects of pollution on society.
Government may also introduce
legislation to reduce the negative externalities associated with negative
externalities. Examples of this include laws to regulate where and when people
can drive, drink and gamble or laws on the minimum age of alcohol and smoking. However,
the problem of underground, black, markets may arise from this in addition to a
possible reduction in the quality of goods affected.
In conclusion government may wish
to combine both market based policies with legislation to make the consumption
and production of demerit goods in order to reduce negative externalities. Both
policies should be used in cases where consumption s price inelastic and the
use of a tax floor or tax may be unable to internalise the externality.
Word Count: 1470
The CORE project. (2017). The
Hoang, P. (2014). Economics for
the IB Diploma