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A negative externality is “a negative effect of a production, consumption or
other economic decision that is not specified a s a liability in a contact” (The
Core Team, 2017). There are lots of different negative production externalities
such as: air pollution from factories, damage to the environment from
industrial ocean fishing, external costs of fertilizers and pesticides used in
farming, noise pollution from the airline industry to name a few. Negative
consumption externalities on the other hand includes for example: fly-tipping
of household waste, effects of passive smoking, impact on family life from
gambling and alcohol addiction, noise pollution from sport and music events. Spill
over costs are created by these externalities which then causes market failure.

To show how this leads to market failure, one has to make a
distinction between the private costs and benefits to the individual consumer
and producer and the social costs and benefits to society as a whole. If we add
together private cost and external cost, the result is social cost. In the
diagram above, P1, Q1 is a free market optimum. This means that the marginal
private cost of consumption and production is equal to the marginal private
benefits. However, if there are negative externalities then the marginal social
cost curve lies above the marginal private cost curve due to the addition of
external costs. If the marginal social cost is positioned away from the
marginal private cost then the marginal external cost of extra output is
assumed 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 associated
with the output Q1. If these externalities are not taken into account, this can
lead to market failure.

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Preferably, one would need another output as shown in the
diagram as Q2 – a quantity which is less than Q1. Without intervention, free
market can overprovide or overconsume goods and services where there are
negative externalities. P2, Q2 in the diagram takes into account the negative
externalities and therefore creates the social optimum output. The equilibrium
level of output delivered by a free market is at Q1 where marginal private
benefit equals marginal private cost and it is allocatively inefficient. One would
assume in this example that there are no externalities arising from consumption
so 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 shaded
area on the diagram shows the social welfare loss which is caused when the
market output supplied is higher than the social optimum which in turn is a
wasteful allocation of resources.

Using corn farming as an example, a farmer uses his private
costs 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 the
water thereby causing fish to die which in turn incurs a negative externality
on the fisherman and the land owners downstream. There are three possible
solutions for these negative externalities – taxation, regulation and property

In order to reduce the amount of production of the goods
that created negative externalities, Arthur Pigou suggested that the government
could 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 is
being laid out or the amount of pollution that is being emitted which means
that 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 the
government requires producers to involve the use of certain technologies to
reduce pollution or emissions. Monitoring costs are low using this method which
is beneficial. There is no need to have someone constantly monitoring the
emissions because it is clear that the technology is present and working. On
the down side, it means that firms do not need to find other ways to further
reduce their emissions resulting in a lack of incentive and innovation. Another
type of regulation is to simply restrict the amount of goods and pollution that
is being created. A disadvantage to this is that monitoring costs are dear.

Property rights play a very big part in negative
externalities as without them it can cause a lot of issues. Coase’s theory
explains this “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”(Ronald H. Coase, 1960). The solution to the
negative externality is simple – assign a property right. In order for these
rights to be successful, they must follow certain requirements. The rights need
to be well defined and specific. They also need to be divisible and have the
ability to be traded. Finally, the rights have to be dependable, enforceable
and recognisable.

If, in the example, the farmer has property rights of the
river, one would assume he does not need to change his routine. However, those
effected downstream (the fishermen) could negotiate with the farmer prompting
him to use less fertiliser on the fields thus reducing the amount contaminating
the river and the quantity of fish dying. If the rights are assigned to the
fisherman, who initially required the farmer to stop putting fertiliser on the
land, then the farmer now has the incentive and knowledge to negotiate the
fisherman. The fisherman would allow a certain beneficial amount of fertiliser
to 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 the
externality. Both parties now know the cost of the externality and are able to
negotiate in order to overcome it. In comparison to other regulations the
monitoring costs are significantly low making it more beneficial. There is also
incentive for both parties to find way to reduce the negative impact on the
social welfare.

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