Negative Externalities

EdExcel Economics 1.3.2

Negative Production & Consumption Externalities

Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid.

Negative production externalities Negative consumption externalities

• Air pollution from factories • Fly-tipping of household waste

• Damage to the environment from industrial ocean fishing • Effects of passing smoking

• External costs of fertilizers and pesticides used in farming

• Impact on family life of gambling and alcohol addiction

• Noise pollution from the airline industry

• Noise pollution from events such as sports matches and concerts

Examples of Negative Production Externalities

Negative production externalities include pollution generated by a factory that imposes costs on others

Air pollution from factories

Pollution from fertilizers

Industrial waste

Noise pollution Collapsing fish stocks

Methane emissions

When answering any question on negative externalities – consider whether the external costs are significant and if so, whether they can be measured and valued accurately

World Carbon Dioxide Emissions from 2005 to 2014

2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

5000

10000

15000

20000

25000

30000

35000

40000

Africa South and Central America Middle EastEurope and Eurasia North America Asia Pacific

Emiss

ions

in m

illio

n m

etric

tons

Negative Externalities in Production – Market Failure

Output

Marginal Private Cost

P1

Q1

Marginal Private Benefit

Negative externalities causes social cost > private cost

Costs, Benefits

£s

Marginal Social Cost

Q2

P2

The equilibrium level of output delivered by a free market is at Q1 where MPB = MPC and it is allocatively inefficient.

We assume in this example that there are no externalities arising from consumption

NoteIf MSC pivots away from MPC then the marginal external cost of extra output is assumed to be increasing

Negative Externalities – The Social Welfare Loss

Output

Marginal Private Cost

P1

Q1

Marginal Private Benefit

Market failure happens when prices do not reflect social costs

Costs, Benefits

£s

Marginal Social Cost

Q2

P2 This is the area of social welfare loss because the market output supplied is higher than the social optimum

NoteThe deadweight loss of social welfare happens when MSC > MPC

Examples of Negative Consumption Externalities

Negative consumption externalities are spillover costs generated and received in the consumption of goods and services.

Vehicle pollution

Household waste

Noise pollution from neighbours

Air pollution from smokers

Traffic congestion

Gambling addiction

Litter from tourists

Spillover costs from obesity

Reducing Externalities – The Use of Pollution Taxes

• One approach is to impose a tax. This is known as “making the polluter pay”.

• A pollution tax increases the marginal private cost causing a fall in demand

• Some economists argue that revenue from pollution taxes should be ‘ring-fenced’ and allocated to projects that protect or enhance the environment.

• For example, money raised from a congestion charge might be allocated towards improving mass transport services

• Revenue from higher taxes on cigarettes might be used to fund better health care programmes.

British Columbia uses a Carbon Tax

China has raised smoking taxes

Emissions Trading Scheme in the EU

Proposed congestion charge for New Delhi

Reducing Externalities: Carbon Trading in the EU

• The EU Carbon Emissions Trading Scheme is cap-and-trade scheme for carbon dioxide

• It sets a decreasing cap for CO2 from energy intensive sectors, and allocates or auctions emissions allowances which can be traded on the open market.

• Businesses need to buy enough emissions allowances – the higher the price, the greater the incentive to cut pollution

• Aviation has just been included in the scheme

The consensus is that a carbon allowance price of at least €30 a tonne is needed to drive investment in low or zero emission technology. But the EU carbon price has rarely reached this level. Indeed in recent years, an excess supply of permits has led to the market price of carbon permits collapsing to below €10 per tonne

Reducing Externalities: The UK Carbon Price Floor

• The UK has introduced a Carbon Price Floor which applies to fossil fuels used for electricity generation

• The minimum price for carbon emissions is designed to provide a stable carbon price signal as a way of internalising externalities

• The minimum Carbon Price Floor started at £16/tCO2 in 2013

• In 2014 the UK government announced a cap of £18/tCO2 from 2016 until 2020

• Carbon prices within the EU ETS system have been highly volatile in recent years

Arguments for a carbon price floor

• Reduces the risks, and thus costs, of investing in low carbon projects

• Helps to reduce carbon price volatility – sends signal to polluters

• Makes low carbon electricity more competitive – boost to renewables

Arguments against a carbon price floor

• Restrict supply of carbon permits to increase the free market price

• A carbon tax is a better alternative and raises useful tax revenues

• Price floor set high might damage international competitiveness

Advantages / Disadvantage of Pollution Taxes

Pros Internalizes the externality and therefore makes the polluter pay

Utilizes the price mechanism to change incentives and choices e.g. to reduction pollution

Raises tax revenue which might then be used to address other market failures

Cons Low price elasticity of demand – tax may not change behaviour

Risk of tax evasion and tax avoidance

May hit lower income families most and cause some social unrest

Topical Examples of Externalities in Transport

Congestion externalities from

vehicles

Noise and air pollution from aircraft

Damage to sea bed from freight containers

The expansion of electric car ownership

and use

Growth of car sharing apps reduce single-car

usage

Investment in light rail infrastructure

Evaluation: Problems with Environmental Taxes

Pollution taxes can lead to government failure: 1. Assigning the right level of taxation: There are problems in

setting the right tax so that private cost will exactly equate with the social cost

2. Consumer welfare effects: Producers may pass on a tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a small effect in reducing demand. Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on lower-income consumers and lead to a widening of inequalities in the distribution of income.

3. Employment and investment consequences: If pollution taxes are raised in one country, producers may shift to countries with lower taxes. This will not reduce global pollution, and create problems such as structural unemployment and a loss of international competitiveness / worsening of the trade balance.

Cutting Emissions From Cars – EU Policies in Action

Regulations on Max CO2 Emissions per km Travelled

A command and control approach

2015: Max 130gms per km +penalties for

exceeding

Effective in driving innovation

Cap on emissions higher than actual

Max limit might shift FDI outside the EU

Bringing vehicles into the Emissions Trading Scheme

Cap on emissions – “allowances” are

traded

Incentives for investment in low

carbon technologiesMost efficient

emissions reducers can sell some

allowancesCollapse in prices has eroded the incentives

for investment

Higher road and fuel taxes

Inelastic demand – fuel taxes generate significant revenues

Easy to collect and adjust the rate

Tax depends on actual fuel consumption not

theoretical levelBut cannot guarantee

target specific reductions in

emissions

Progress in Cutting Emissions From Cars in the UK

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014120

130

140

150

160

170

180

171.4 169.4167.2

164.9

158

149.5144.2

138.1133.1

128.3124.7

Year

CO² i

n g/

km

Average carbon dioxide emissions from new cars in the UK between 2004 and 2014 (in grams per kilometre)

Externalities and Government Regulations - Examples

• Health and Safety at Work Act covering all businesses.• Renewables Obligation Certificates to encourage the supply of

renewable energy (+ penalties for not meeting targets)• Councils using by-laws preventing public consumption of alcohol.• Consumer protection legislation e.g. against dangerous goods• Laws such as the ban on smoking in public places from July 2007• The European Union has introduced directives on how durables

such as cars, batteries, fridges freezers should be disposed of• The EU also imposes increasingly tough rules on carbon emissions

from vehicles which all EU manufacturers must meet• Speed limits on roads and weight limits for lorries • Quotas on how much fishing can take place in EU waters• Bans on sale of certain substances / minimum age of legal sale• Lowering alcohol limit for drivers – reduced by Scotland in 2014

Evaluating the Impact of Industry Regulations

The case for regulating negative externalities

Costs / disadvantages of adding extra regulation of industries

• Regulations act as a spur for business innovation e.g. to cut the level of carbon emissions

• High cost of enforcement / administration of laws / regulations

• Regulations may be more effective if demand is unresponsive to price changes

• Regulations can lead to unwelcome unintended consequences / Govt failure

• Regulations can be gradually toughened each year – this will help stimulate capital investment

• The cost of meeting regulations can discourage small businesses and lower competition in markets

Negative Externalities

EdExcel Economics 1.3.2