A negative externality is “a negative effect of a production, consumption orother economic decision that is not specified a s a liability in a contact” (TheCore Team, 2017).
There are lots of different negative production externalitiessuch as: air pollution from factories, damage to the environment fromindustrial ocean fishing, external costs of fertilizers and pesticides used infarming, noise pollution from the airline industry to name a few. Negativeconsumption externalities on the other hand includes for example: fly-tippingof household waste, effects of passive smoking, impact on family life fromgambling and alcohol addiction, noise pollution from sport and music events. Spillover costs are created by these externalities which then causes market failure.To show how this leads to market failure, one has to make adistinction between the private costs and benefits to the individual consumerand producer and the social costs and benefits to society as a whole. If we addtogether private cost and external cost, the result is social cost. In thediagram above, P1, Q1 is a free market optimum. This means that the marginalprivate cost of consumption and production is equal to the marginal privatebenefits.
However, if there are negative externalities then the marginal socialcost curve lies above the marginal private cost curve due to the addition ofexternal costs. If the marginal social cost is positioned away from themarginal private cost then the marginal external cost of extra output isassumed to be increasing. The difference between the two curves (MSC and MPC)shown by the dotted red vertical line is the external cost which is associatedwith the output Q1. If these externalities are not taken into account, this canlead to market failure.Preferably, one would need another output as shown in thediagram as Q2 – a quantity which is less than Q1.
Without intervention, freemarket can overprovide or overconsume goods and services where there arenegative externalities. P2, Q2 in the diagram takes into account the negativeexternalities and therefore creates the social optimum output. The equilibriumlevel of output delivered by a free market is at Q1 where marginal privatebenefit equals marginal private cost and it is allocatively inefficient. One wouldassume in this example that there are no externalities arising from consumptionso the social optimum is at P2, Q2 when we take into account the externalities.There is also a deadweight loss of welfare due to market failure.
The shadedarea on the diagram shows the social welfare loss which is caused when themarket output supplied is higher than the social optimum which in turn is awasteful allocation of resources. Using corn farming as an example, a farmer uses his privatecosts such as fertiliser to help his crops grow in both quality and quantity.However, some of this fertiliser goes into a river nearby and contaminates thewater thereby causing fish to die which in turn incurs a negative externalityon the fisherman and the land owners downstream.
There are three possiblesolutions for these negative externalities – taxation, regulation and propertyrights.In order to reduce the amount of production of the goodsthat created negative externalities, Arthur Pigou suggested that the governmentcould introduce a tax on the producers. However, this found difficulty in monitoring.With regards to the example, it is difficult to know how much fertiliser isbeing laid out or the amount of pollution that is being emitted which meansthat the cost of monitoring is high. This is seen as a disadvantage.
Regulation, on the other hand, has many different varieties.One for example is through technology specifics methods. This is where thegovernment requires producers to involve the use of certain technologies toreduce pollution or emissions.
Monitoring costs are low using this method whichis beneficial. There is no need to have someone constantly monitoring theemissions because it is clear that the technology is present and working. Onthe down side, it means that firms do not need to find other ways to furtherreduce their emissions resulting in a lack of incentive and innovation. Anothertype of regulation is to simply restrict the amount of goods and pollution thatis being created.
A disadvantage to this is that monitoring costs are dear.Property rights play a very big part in negativeexternalities as without them it can cause a lot of issues. Coase’s theoryexplains this “Under perfect competition, once government has assignedclearly defined property rights in contested resources and as long astransactions costs are negligible, private parties that generate or areaffected by externalities will negotiate voluntary agreements that lead to thesocially optimal resource allocation and output mix regardless of how theproperty rights are assigned”(Ronald H. Coase, 1960).
The solution to thenegative externality is simple – assign a property right. In order for theserights to be successful, they must follow certain requirements. The rights needto be well defined and specific. They also need to be divisible and have theability to be traded. Finally, the rights have to be dependable, enforceableand recognisable.
If, in the example, the farmer has property rights of theriver, one would assume he does not need to change his routine. However, thoseeffected downstream (the fishermen) could negotiate with the farmer promptinghim to use less fertiliser on the fields thus reducing the amount contaminatingthe river and the quantity of fish dying. If the rights are assigned to thefisherman, who initially required the farmer to stop putting fertiliser on theland, then the farmer now has the incentive and knowledge to negotiate thefisherman. The fisherman would allow a certain beneficial amount of fertiliserto be used on the fields but less than the amount the farmer was using before.In each scenario, a solution is made to internalise or overcome theexternality. Both parties now know the cost of the externality and are able tonegotiate in order to overcome it.
In comparison to other regulations themonitoring costs are significantly low making it more beneficial. There is alsoincentive for both parties to find way to reduce the negative impact on thesocial welfare.