Externalities are defined as the third-party spillovers arising from the production or consumption of goods and services on which there is no appropriate compensation is paid. The externalities are likely to create market failure in the sense that the price mechanism which involves the demand and supply forces might not reflect the real equilibrium price because some of the costs which emanate from externalities are not considered, that is the price mechanism is likely not to consider the social costs and also the social benefits. The study of externalities looks much on the relationship between the environment and also the economy of one given territory.
Externalities can either be positive externalities or negative externalities, depending on whether it is affecting the environment positively or negatively. The positive externalities are effects on the third party which benefit the party from either the consumption or production of goods and services, in the sense that the third party normally enjoys the spillovers that he or she does not pay for, for example, a neighbor having a flower garden can not restrain another neighbor from enjoying the aroma from the garden, thus a positive externality because the neighbor is enjoying the benefits equivalent to the owner of the flower garden without paying for services. A negative externality involves inflicting a cost to a third party during the production or consumption of goods and services, whereas this third party is not compensated for the damages caused. For instance, a factory that emits smoke is likely to affect the third parties, who are not involved in the production process, and for this case, the smoke is certain to affect the neighborhood of the factory by the smoke settling on their premises which will require the neighbors to be repainting their buildings more frequently than when the factory would have not been located at where it is, thus a cost that is not compensated for, hence negative externalities.
The occurrence of positive and negative externalities provokes the need to consider the difference between the private costs and also the social costs. The production units normally consider the direct costs that they use in the production of goods and services in their accounting systems which are regarded as private costs (Peterson, 33). The private costs are not a real reflection of the cost of producing certain goods and services because they do not include the costs that are incurred by the third party as externalities, thus the combination of both the private costs and the costs inflicted on society by externalities gives social costs, which is a true reflection of the costs that are involved in the production of goods and services. Thus
Social Costs = Private Costs + Externalities
Simultaneously, there are also Social benefits, which imply the sum of private benefits and also the benefiting externalities, wherein this case are positive externalities, thus
Social benefits= Private benefits + Externalities.
where private benefits are the utilities that are derived from the consumption of a good by an individual who had incurred an economic sacrifice to attain the good or service.
Smoking is perceived by the majority of persons as a negative externality, at the look at its benefits and the costs to the society. Smoking has private costs to the smoker himself and also to the society where the smoker resides. The private costs that come with smoking include the cost of the cigarettes, the cost to one’s health, and also the cost of one keeping his or her clothes and home generally clean, in the case of cigarette smoking. Smoking also has costs on the third party who is not smoking because he or she will incur health costs by inhaling the smoke from the smoker as secondhand smoker, smoking will also increase the costs of cleaning homes and also the increased insurance costs. Smoking externalities are likely to take a wide range including smoking from running engines and also the burning of other carbon substances. However smoking at some point can be perceived as positive externalities and more especially to the fellow smokers, because they are likely to enjoy the smoke that will come from their neighbor smoking, thus a benefit over which they have not paid for, in the case of cigarette.
Externalities are certain to cause market failures, meaning that the market prices are certain to be erratic in estimating the equilibrium price of one given product. This situation arises when the externalities are not factored in in capturing the total costs of production or the total benefits of consumption. The illustration of the price mechanism failure can be done by the use of the normal demand and supply curves.
In a situation where there are negative externalities, the marginal social cost is always greater than the private marginal cost, due to the additional costs that arise from the externalities. The Private marginal cost is less than the marginal private cost because it does not factor in the costs inflicted by the externalities, otherwise it considers only the costs which are used to produce the goods and services. The inaccuracies that are involved in the estimation of costs and benefits are certain to affect the efficient allocation of the resources given that the efficient allocation of resources is guided by the demand and the supply forces. The firms normally underestimate the costs by just considering the private costs, and in this case, they get an incentive for producing more output due to the underestimated cost, hence pushing the supply curve outside to the right due to the increased output level. This output level is not efficient because it does not include all the costs, especially the costs incurred by the third party due to externalities, hence an inefficient allocation of resources. In the case of positive Externalities, where the third party enjoys the benefits without having to pay for the services received, the demand for a certain product or service
normally fall because one can still have the utility without paying for it, thus shifting the demand function back and to the left side, which will imply an inefficient allocation of resources resulting from the excess supply over the demand, thus a market failure because the resources have not to be allocated optimally.
The existence of market failures caused by externalities like smoke requires external intervention to ensure that the resources are allocated optimally. And the main aim of the interventions is to ensure that the costs and the benefits are accounted for accordingly and more, especially the ones associated with externalities. some of the possible interventions include the following;
The government intervention through taxation will ensure that the correct cost, and in this case social cost is passed to the producers, which provides an incentive of discouraging them from producing more output, thus observing the optimal production level. Taxation on the products produced is perceived as a cost of production, thus an imposition of a tax on a given commodity will be felt by the producers as an additional expense. The imposed tax will be reflected on the increased prices of the products, and this has an impact of reducing the demand for a product following the law of demand, which implies that a price increase will lead to a decrease in demand. The decrease in demand implies less consumption of that product hence reduced externalities. An effective tax rate should be imposed, which should be just equivalent to the externalities cost to create a proportionate decrease in demand for the product that is causing the negative externalities according to the Pigouvian Tax, which explains that tax should be imposed according to the amount of pollution caused by the use of a given product on consumption or in production. The tax collected should be used to correct the harm that has been caused by the externalities in the case where the production or the consumption of the good is tax inelastic, thus compensating for the costs incurred by the third party, hence the optimal allocation of resources. Therefore smoking can be regulated by imposing a proportionate tax that will reduce the production to a given desired or optimal level.
The government also through its executive powers, can impose some restrictions on the number of certain goods and services that are supposed to be produced depending on the predetermined production level which is certain to ensure optimality. This should be applied in the situation where the production and the consumption good and services are tax inelastic, that is when they do not respond to the tax changes, however, this can be perceived also as another new form of market failure because the output is not determined in the market, but rather predetermined by the government authorities as their accuracy is not certain to reflect the optimal allocation of resource due to the unpredictable nature of the market price mechanism.
Negative externalities can also be controlled by creating public awareness which will inform the public on the effects of smoking for instance. This will create the public concern of preventing more pollution through smoking, hence a way of reducing the cost of externalities in the society, assuming that the society is composed of rational persons who can make informed judgments over their various actions as regard to the environmental protection.
Negative externalities can also be solved by internalizing the effects through the formation of mergers by the firms which are producing the product whose consumption or production possesses negative externalities. The formation of a merger will reduce competition among the firms in a certain industry, thus there is a tendency for operating almost like a monopoly which entitles the merger the powers to set prices and also to determine the output level. This situation will enable the firms to achieve the predetermined profits even though their output might be low in the process of controlling the negative externalities that are either to occur during
production or the consumption of the product, than when it was to be in the competitive market, where firms maximize profits by increased output levels among other profit-maximizing strategies (Fund for Public Policy Research, 51).
The establishment of property rights is also another factor that can be used to limit the negative externalities, wherein in this case property right is a legally established title to the sole ownership of a given scarce resource which is enforced by the court order.
Property rights will restrain the polluting agents from inflicting costs to the property owner thus avoiding negative externalities. For example, a court may reinforce some areas as being non-smoking zones, and in this case, the court order is certain to restrain the smoking agents from smoking, thus an effective mode of controlling smoking, hence controlling the negative externalities.
The government can also issue tradable pollution rights to firms that cause negative externalities. The tradable pollution right normally possesses a fixed pollution level, and in this case, firms that pollute the environment will be forced to adopt the technologies which pollute the environment less than the currently used technologies in the process of the firms trying to minimize their production cost to maximize their profits, thus an effect meaning of controlling negative externalities.
Smoking causes negative externalities which makes the marginal social cost higher than the private marginal costs. This gap causes an inefficient allocation of resources in the society that calls for intervention in correcting the mess. The possible corrective measures include taxation, setting of regulations, creating public awareness, issue of property rights and also the issue of tradable property rights by the government.
Fund for Public Policy Research, Studies in taxation, Public Finance, and Related Subjects, Michigan University Press, 2001.
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Peterson A.,, Healthy Markets? : The New Competition in Medical care, Duke University Press, 1998.