The Activities of Firms - Assignment Example

The activities of firms may cause spillover effects, called externalities. These externalities can be beneficial for the society, positive externality, or have an adverse effect on it, negative externality. This paper cites the opinions of experts who propose various solutions to the emission of gases, a negative externality. The paper further examines the viability of each of the proposed solutions by identifying the various costs and benefits involved. The paper concludes by discussing which policy needs to be implemented.

Before considering the five questions we must first recognize that the example of gas emission by a local power plant is that of a negative externality. This is because emissions of such gases cause pollution which is harmful to humans, animals, and plants. Although the society is not involved in the emission of these gases it has to bear the costs (Perloff 2003). Hence the given example is a perfect case of a negative externality.

1. Although there are a number of ways to combat the negative externality, a policymaker must carefully decide on a policy before implementing it. There are a few costs and benefits of each policy and the policymaker should first carry out a Cost Benefit Analysis (CBA) of all the alternative policies before their final decision. Blinder (1987) has the following to say about solving the negative externality problem:

“Especially when faced with environmental externalities, economists have almost universally objected to government regulations that mandate specific technologies (especially “best-available technology”) or business practices. These approaches make environmental cleanup much more expensive than it has to be because the cost of reducing pollution varies widely from firm to firm and from industry to industry. A more efficient solution is to issue tradable “pollution permits” that add up to the target level of emissions. Sources able to cheaply curtail their negative externalities would drastically cut back, selling their permits to less flexible polluters.”

Another solution proposed by Coase (1960 in his Coase Theorem is:

“Under perfect competition, once the government has assigned clearly defined property rights in contested resources and as long as transactions costs are negligible, private parties that generate or are affected by externalities will negotiate voluntary agreements that lead to the socially optimal resource allocation and output mix regardless of how the property rights are assigned”

Hence the two possible policies that a policymaker can adopt are using tradable pollution permits or government-defined property rights.

2. In the first policy the government will give licenses to firms to pollute. Each license will specify the level of pollution allowed to the firm. Depending on its level of pollution a firm can buy a certain license. Firms that pollute less than the permissible level can trade their license with those firms that cannot keep their pollution levels low. In this way, firms are given the incentive to pollute less (Bamford, Brunskill, Cain, Grant, Munday, Walton 2002).
   The second policy assumes that there are negligible transaction costs. According to Sloman (2007) making someone the owner of the air around the power plant eliminates the effect of a negative externality. Here the two parties involved are the power plant producing the negative externality and the society living in the vicinity of the power plant that is affected by the emissions. If the power plant owns property rights to the air then the society pays the power plant to reduce pollution by lowering its production to the optimal level. However, if the society is the owner then the power plant will have to pay compensation money to the society for the pollution they cause by increasing production from the optimal level.
3. If the policy maker implements the tradable permits for gases emission it will have benefits for the power plant and government apart from reduced emissions. Firstly the power plant will have the incentive to pollute less by reducing its emission levels below the permissible level so it can trade the permit with some other firm. This would provide an added source of revenue for the power plant. Similarly, the government can also gain from this policy by selling licenses to the firms. The selling of these licenses will generate revenue for the government other than tax revenue.

If the second policy is implemented it will result in benefits to the power plant and the society. If the property rights are with the society then the society will receive compensation from the power plant in the form of money whereas if the property rights lie with the power plant it will receive money from the society to pollute less.

Hence both policies have their own benefits.

4. In the first policy the government will face costs related to monitoring the emission levels. It is a tedious job to monitor if the emission levels are within or equivalent to the permissible level and requires a lot of staff to be hired as there are many firms in the economy and not just one firm. The second policy also has costs associated with it. In order to decide who gets the property rights the two parties must settle the issue legally in court. Such cases are expensive to fight as they have a huge amount of legal fee that needs to be paid.
5. In order to decide which method is the best to reduce emissions a Cost Benefit Analysis (CBA) needs to be done. In a CBA all the costs and benefits of certain policies are identified and taken into account. The costs are measured against the benefits. If the costs are higher than the benefits then there is no point in implementing the policy. If the benefits outweigh the costs then the policy that has more net benefit is the one that needs to be adopted (Grant 2000).