How can governments address the problem of
climate change through implementation of
environmental policies in modern world?
Name: Adrian Wong
Professor: Russ Houldin
How does Negative Externalities occur?
Neoclassic economics have made us believe that in a free market, the three main actors – firms, consumers, and owners of production – will act in their self-interest and optimize their returns (“Free Market Economy.” 2010). By putting this assumption into the context of modern economy, free markets produce the best possible outcome in terms of the allocation of resources (Ragan, 2005). This is when the concept of Adam Smith’s “invisible hand” applies, where billions of individual transactions create a system in which goods are produced according to the level of demand (Conway, 2009). When the market is not producing the right amount, market failure occurs because resources are not being used properly.
Market failure happens when the price mechanism fails to take into account all costs and benefits of producing and/or consuming the goods (Ragan, 2005). If the Marginal Social Benefits (MSB) in the production or consumption of goods is not equal to the Marginal Social Costs (MSC), it means that the market is not producing socially optimal level of goods (either too few or too many). Therefore, the market will fail to supply socially optimal levels of goods for the market.
There are three reasons for market mechanism failure:(1) existence of externalities (for example, air pollution and attractive garden); (2) imperfect competition (such as monopolies or oligopolies); and (3) a missing market (when goods are underproduced, such as education and health care). Out of the three reasons, existence of externalities is the most important factor related to the environment. It has the highest impact on the environment that people are living in.
Therefore, governments should focus on this aspect and set
environmental policies by using carbon taxes, tradable permits and extension of property rights to reduce the number of externalities. This paper will be based on economic theory and real-world case study approach to illustrate environmental policies that governments are currently using.
What is negative externality?
The term negative externality is defined as an action consumers or producers take that has a negative impact on a third party (Besanko, 2009). In a theoretical approach, negative externality happens when the marginal social cost (MSC) is greater than the marginal private cost (MPC). Traffic congestion is one of the best examples that cause a negative externality. In this case, the market fails to measure the true costs of production that the society bears, also known as the Marginal External Cost (MEC). Because there is a positive relationship between the level of traffic congestion and asthma (Grimfeld, 1999; Thillaiampalam, 2005; McDonald, 2010), people who are affected by inhaling polluted air because of traffic congestion will go to public clinics for medical treatments, which are paid by the society (Cifuentes, 1995). This cost is more visible at the society level, but not as visible in the private level. By using a standard demand-and-supply diagram in relation with air pollution, it can illustrate negative externalities.
The vertical axis represents the price of a good, whereas the horizontal axis represents the demand for that good. In an unregulated market, the equilibrium price and quantity of goods is determined at the intersection of the supply curve or MPC and the demand curve or MSB: P0, Q0. These goods provide benefits to people, but also causes pollutions. The cost for producing these goods (e.g. material costs, labor costs, energy costs) for the producers is just MPC, where the harmful effects of pollution (i.e. lowering air quality, increase incidence of asthma, fewer healthy days) are paid by the society, which is the marginal external cost (MEC). Therefore, the output will be set at Q0 and P0 rather than at the socially optimal price and quantity at P* and Q* or when MSC=MSB. The vertical points between ‘a’ and ‘b’ re the negative externalities and the area of ‘C’ is the deadweight lost or welfare loss (burden) to the society in producing these units.
Many governments use this standard supply-and-demand diagram to develop penalties for air pollutions.
This is because the graph is a powerful tool and
governments can use it to measure the effectiveness of different policies, such as the one, which will be illustrated below.
Environmental Policy: Carbon Taxes and Climate Change
Factories produce of greenhouse gases (GHGs) that are released into the atmosphere, which is a clear example of negative externalities. Research results have shown that greenhouse gases are responsible for climate change, such as causing floods, hurricane, and desertification (Boston, 2011; Farrugia, 2010). These disasters are happening in a global scale and cost billions of dollars loss each year. Based on the economic theory, the market for carbon-based fuels, such as oil, coal, and natural gas, internalize private costs only, and it does not internalize the external cost that the society is paying.
From an economic perspective, governments can rectify this problem by imposing P...