Externalities Instructor Name Abstract 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…
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Externalities 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 for humans, animals and plants. Although the society is not involved in the emission of these gases but 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 policy maker must carefully decide on a policy before implementing it. There are a few costs and benefits of each policy and the policy maker 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 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 policy maker 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 who cannot keep their pollution levels low. In this way firms are given an incentive to pollute less (Bamford, Brunskill, Cain, Grant, Munday, Walton 2002). The second policy assumes that there are negligible transactions 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 compensating 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
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