Externalities and Market Structure - Example

Economics Student’s Name Institutional Affiliation Part A Externalities are a common occurrence in many economic systems. An externality is simply the spill- over effects that arise from the production or the consumption of a certain good or service. Usually, no compensation is made for the externality (Ater 2008). Externalities have been known to cause market failure in the event that the price mechanism in that particular market does not fully account for costs incurred socially or for the benefits attained. An externality is either said to be a positive one or a negative one (Bithas 2011). A negative externality is said to occur in the market when the firm or individual responsible for making a particular decision is not fully accountable for the cost incurred or associated with that decision. If for example, a good in the market is having a negative externality, then the cost imposed on society is greater than the cost the individual paying for the good will incurs (Ater 2008). A negative externality always amounts to inefficiencies in the market or even failure unless mechanisms are put in place to prevent such (Harris 2003). This occurs mainly because the consumers purchasing the good decide at the point where their marginal costs will equal their marginal benefits and as such, they do not put into consideration the cost of the negative externality. In the case of a market system which is not regulated, and a negative externality occurs the producers take no charge of costs incurred but rather, they pass the burden to society (Haviv and Ritov 1998). An example of a negative externality is pollution. For example, a chemical producing company will let out poisonous emissions into the atmosphere. The firm will only incur costs associated with a production of the chemicals, but the people living around that company will pay for the negative externality. This is because the emissions will make them sick, and they will have to incur expenses in footing the medical bills (Hillman 2009).Government intervention is necessary to address the case of negative externalities. This is because, the cost of negative externalities in passes on to the society as opposed parties accountable for that decision that led to the occurrence of a negative externality especially in unregulated markets. The government is forced to formulate policies and also and procedures that will help control the occurrence of negative externalities in the market (Frank et al 2007). The policies are meant to make the persons responsible for the decisions resulting to externalities accountable for the costs incurred. Thus, the government intervenes to correct the market failure, improve the general economic performance and also to reduce the disparity in allocation of resources and also income (Harris 2003). Government intervention is mainly through imposing a tax penalty on the person or firm responsible for the negative externality. By doing so, the marginal cost of the producer is increased and as; thus, he is forced to reduce the output that causes the negative externality (Etro 2009). There are several methods of correcting negative externalities in market systems. One of them is by internalizing the externality. This can be achieved by making the individuals responsible for the externality directly accountable for it (Frank et al 2007). Calculations can be done establish the cost of the externality and then charge the firm or individual the exact amount (Mankiw 2004). A tax level can also be imposed on persons who exceed a certain predetermined level of externality. This method of correcting externality is good since it helps in controlling the level of externality especially pollution externality. It also makes those responsible for the negative externality directly accountable as opposed to passing the burden on to society. The problem associated with this mechanism is that it might be hard to measure the level of pollution or even determine who exactly is responsible for it (Harris 2003). The second method of correcting negative externalities is through taxation. Those who create the negative externalities are taxed (Heung 2005). The taxes are known as the pigouvian taxes. This method is beneficial since it holds accountable the persons responsible for the negative externality. The shortcoming of this mechanism is that it might still be hard to identify who is accountable for the negative externality. The other problem associated with this mechanism is that, producers in some way may pass the burden to consumers if the demand curve for the good in question is elastic. The taxation method may also result in cost push inflation if the taxes are too high and as thus this may affect the economy causing harm to the society at large (Hillman 2009). Part B A competitive market is one characterized by many buyers and sellers who sell homogenous products. In this market, no single seller or buyer can dictate how much will be produced in the market or at what prices the commodities will be sold. The consumers pride in the variety since all producers sell the same goods and as thus quality is what attracts consumers to purchase from any given trader in this market (Ater 2008). There are varied reasons for existence of such a market structure, but the major motive is profit making and maximization. There is no product differentiation in this type of market, and there is ease of entry and exit. The market prices are purely determined by the forces of demand and supply whereby, the higher the demand, the higher the supply and consequently the higher the price (Etro 2009). The converse is true (Frank et al. 2007). Mountain Company operates in this market, and it deals with production of laboratory chemicals. The production of these chemicals results in the emission of poisonous of gases in the atmosphere resulting to a negative externality to the people living around that region since it leads to the occurrence of acidic rain (Heung 2005). This being a competitive market, the market quantity and prices are purely determines by the market forces which are the demand force and the supply force and this is at the point where the market supply curve intersects with the demand curve given by the market forces. The diagram below shows that (Boyes & Melvin 2008). This happens regardless of the existence of an externality or not. Supply curve P* Demand curve Q* The producers are willing to supply quantity Q* in terms of production, and the consumers can only pay price P* as dictated by demand and supply. This happens regardless there is an externality or not (Ater 2008). Due to the emissions produced by mountain company that result in a negative externality which is pollution since the market is not regulated. When this externality occurs, the producers are not in any case held accountable for the costs caused by the negative externality. The costs resulting from the externality are passed on to the society living in within the environs whereby Mountain Company is situated (Harris 2003). This means that Mountain Company incurs lower marginal costs as opposed to the way it would have been if the supply curve would shift in the right side of the supply curve of the society. This causes the supply curve to increase upwards. . Consequently, the amount available in the market to be bought is increased. This implies that consumers buy much of the product than would be economically efficient. Mountain Company as thus produces so much of the product and sells it. As marginal benefit should always equal marginal cost, dead weight loss affair creeps in as shown in the diagram below (Heung 2005). S = MC S1 = MC-X P1 B P* C A D = MB Q1 Q* Dead weight loss is represented by the region ABC. The diagram shows the effects of the negative externality, which is pollution in the environment or society. The S = MC curve represents the supply curve which is also the marginal cost curve. The S1 = MC- X represents the mountain's company marginal cost curve which is the representation of the negative externality in society. Mountain company should produce Q1, and that would be the optimum production quantity, but instead, it produces Q* as the production quantity. The result is a dead loss weight welfare loss which is represented by the region ABC (Haviv & Ritov 1998). In this market, the government has had to intervene so as to salvage the situation. Among the reasons why the government has to intervene is to promote equal distribution of resources in the market. Another reason is to promote efficiency (Ater 2008). Finally, the government has had to come in to help reduce the effects of the externality that would otherwise lead to market failure. The government is forced to formulate procedures and those policies that would help in enhancing the efficiency and thus minimize or completely eradicate the dead weight loss of welfare that has culminated from the market overproduction done by Mountain Company. The government has introduced a tax policy to help curb this negative externality. If there were no negative externalities in this market, then the introduction of the tax would be inefficient since the allocation in the market is already proper (Hillman 2009). To implement the tax policy, the government has had to determine the market demand and the supply curve of Mountain Company (Bithas 2011). With that information, the government has been able to implement a tax that is equal to the amount of externality that Mountain Company has caused that is the acid rain. By imposing a tax on the chemical that cause the acidic rain, the government will have internalized the externality (Mankiw 2004). The tax that the government has imposed has been meant to make accountable the person or firm responsible for the externality accountable for it, in this case, the Mountain Company. The magnitude of the negative externality in most cases is always equal to the difference that is there between marginal social cost curve that is the societal curve and the private cost curve that is the cost curve for Mountain Company. The government has set the tax at the level whereby the where these two curves intersect. The result would be that the marginal private cost curve will shift until it falls perfectly on the marginal social curve and as thus the externality is corrected. Equilibrium will thus be achieved (Hillman 2009). The main problem the government has faced in its taxation process to rectify the externality has been that it is not possible to measure accurately the amount of the externality. Pollution is a hard phenomenon to measure and in most cases, the government has been forced to speculate as it cannot get the real figures, or errors occur in the cause of measurement and hence it is unable to impose the correct taxation. The other problem has been that, this being a competitive market, and there are other producers who produce the same commodity, and as; thus, it makes it difficult to establish who exactly is responsible for the externality and to what extent (Ater 2008). Part C In the above case scenario, other mechanisms can also be used so as to reduce the effect of the negative externality (Bithas 2011). Another mechanism that can be employed is the use of subsidies. As seen in the case above where the government has used tax the correct the externality, the tax effect has been to reduce the quantity produced and raise the price. This cannot apply especially if the good in question has external benefits. If the commodity in question has benefits, the government can make use of subsidies (Heung 2005). Payment of subsidies will make the production increase and subsequently lower the prices in the market. As thus the society will get lower prices as thus they will not bear the cost of the externality. The economic reason behind this mechanism is that, the government may impose taxes on Mountain Company for causing the externality (Mankiw 2004). On the other hand, the chemicals that the mountain company manufactures may have other social benefits such as, provision of employment to a person living around. Imposing a high tax may result in Mountain Company cutting down on its workforce since it cannot sustain the high labour and as thus lead to unemployment (Haviv & Ritov 1998). This would not be economically advisable since unemployment is a sign of deteriorating economy. Another economic justification is that, the company maybe importing its products abroad to other countries that earn the country foreign exchange and also enhances good relations. The government may opt for subsidy rather than taxation (Frank et al. 2007). The final economic justification for this would be that, the company maybe a foreign one with major investment in the country and thus imposing taxation on them would be to the disadvantage of the economy as so the best way to deal with would be through subsidization (Ater 2008). Another method would be through government regulation whereby the government carries out regulation measures. The taxation process may not achieve the desired results as expected since it is always difficult to measure the extent or the actual amount of the externality (Etro 2009). If the government finds out the problem is too much, and the society is the one that is suffering, then the best way to deal with the externality would be to terminate the operations of the company or individual causing the negative externality, in this case it would be, Mountain Company (Etro 2009). The economic justification for this is that, Mountain Company in its activities causes a negative externality, in this case is the emission of poisonous gases that result in acidic rain (Hillman 2009). The damage caused by the acidic rain or rather by this negative externality has far reaching effects that are more expensive to remedy and the cost that this imposes on the society is too large and hence, the government having the society in mind, opts to terminate the activities of the company since they have much far reaching effects than can be handled (Harris 2003). The last method of dealing with the externality would make Mountain company compensate directly to the society that it has affected due to its activities. This can be through job creation or other means of giving back to the societal. Economically, it would be creating a balance between the cost and benefit accruing from the externality (Boyes & Melvin 2008). References Ater, I. (2008). Essays on externalities and market structure. Bithas, K. (2011). Sustainability And Externalities: Is The Internalization Of Externalities A Sufficient Condition For Sustainability? Ecological Economics, 70(10), 1703-1706. Boyes, W. J., & Melvin, M. (2008). Economics. Boston [u.a.: Houghton Mifflin. Etro, F. (2009). Endogenous market structures and the macroeconomy. Dordrecht: Springer. Frank, R. H., Bernanke, B., & Frank, R. H. (2007). Principles of microeconomics. Boston: McGraw-Hill/Irwin. Harris, L. (2003). Trading and exchanges: Market microstructure for practitioners. Oxford [u.a.: Oxford Univ. Press. Haviv, M., & Ritov, Y. (1998). Externalities, Tangible Externalities, and Queue Disciplines. Management Science, 44(6), 850-858. Heung, S. N. S. (2005). Economic explanation: Selected papers of Steven N.S. Cheung = Zhang Wu Chang yen yu lun wen xuan. Hong Kong: Arcadia Press. Hillman, A. L. (2009). Public finance and public policy: Responsibilities and limitations of government. Cambridge: Cambridge University Press. Mankiw, N. G. (2004). Principles of microeconomics. Mason, Ohio: Thomson/South-Western. Read More