Market failure #3 - negative externalities

Summary

This video explores the economic concept of negative externalities, focusing on both production and consumption. It explains how external costs from production (like pollution) and consumption (such as smoking) lead to market failures, with overproduction and overconsumption as the main issues. The video also reviews three government intervention options for each: taxing firms, stricter environmental regulations, and tradable emission permits for production, and banning consumption, taxation, and education/advertising for consumption. The goal of these policies is to internalize the externalities and move towards the optimal market allocation.

Takeaways

• 😀 Negative externalities occur when production or consumption of goods impose costs on third parties, leading to market failure.
• 😀 In production, negative externalities like pollution result in social costs exceeding private costs, causing welfare loss.
• 😀 The government can correct production-related market failures through taxation, regulations, or tradable permits.
• 😀 Taxing firms increases their production costs, shifting the marginal private cost curve upwards and internalizing externalities.
• 😀 Stricter environmental standards can regulate pollution but may lead to higher costs and job losses.
• 😀 Tradable permits (cap and trade) allow firms to buy and sell pollution allowances, but setting proper pollution caps can be challenging.
• 😀 Negative externalities of consumption occur when consuming goods like cigarettes imposes harm on others, such as second-hand smoke.
• 😀 The government can address consumption externalities by banning or taxing the goods, or using education and advertising to reduce demand.
• 😀 Banning the consumption of demerit goods can reduce harm but may create black markets and lead to unemployment.
• 😀 Taxing demerit goods increases costs, but the inelastic demand for these goods may limit the effectiveness of this approach.
• 😀 Education and negative advertising can shift consumer behavior by informing them of the risks, though these measures can be costly for the government.

Q & A

What are negative externalities of production?

Negative externalities of production occur when the production of a good or service creates external costs that negatively affect third parties, such as pollution from a factory harming the surrounding community.

How do negative externalities of production affect social welfare?

They lead to a misallocation of resources, where goods are overproduced because the marginal social cost (MSC) is higher than the marginal private cost (MPC), creating a welfare loss, which is represented as a triangle between the two curves on a diagram.

What is the optimal allocation of resources when negative externalities of production occur?

The optimal allocation occurs when marginal social cost equals marginal social benefit (MSC = MSB). However, in the case of negative externalities, the production level is higher than the optimal level, leading to overproduction.

How can the government correct negative externalities of production?

The government can use several methods: taxing the firm to internalize the externality, passing stricter environmental regulations, or issuing tradable emission permits (cap-and-trade system) to limit pollution.

What are the challenges of taxing firms to address negative externalities?

The challenges include determining the appropriate tax rate, measuring the exact amount of pollution, and ensuring that the tax effectively reduces the externality without creating unintended consequences.

What are demerit goods, and how do they relate to negative externalities of consumption?

Demerit goods are goods that are overconsumed because individuals do not fully understand their harmful effects. Their consumption imposes external costs on third parties, such as second-hand smoke from cigarettes affecting non-smokers.

How do negative externalities of consumption affect social welfare?

Negative externalities of consumption result in overconsumption because the marginal social benefit (MSB) is lower than the marginal private benefit (MPB). This misallocation leads to a welfare loss represented by the difference between these two curves.

What are the government’s options for addressing negative externalities of consumption?

Governments can ban the consumption of the good, impose taxes, or use educational programs and negative advertising to reduce demand and inform consumers about the harmful effects of the good.

Why is taxing demerit goods like cigarettes often not fully effective?

Taxing demerit goods may not be fully effective because the demand for these goods is often inelastic, meaning consumption doesn't decrease significantly even with higher prices. Additionally, high taxes can encourage smuggling or cross-border purchases.

What role does education play in addressing negative externalities of consumption?

Education and negative advertising can shift the marginal private benefit curve leftward, decreasing demand for harmful goods like cigarettes by increasing public awareness about their negative effects on health and society.