Question

Discuss how a negative externality prevents a competitive market from allocating resources efficiently.

Answer 1

Allocative Efficiency

Allocative Efficiency refers to a situation  in which the market price for each good is equal to that good's marginal cost. When the price is equal to the marginal cost we can consider the market to be efficient.Allocative Efficiency is attained when the sum of consumer surplus and producer surplus is maximized.

When price is equal to Marginal Cost we can say that resources are utilized efficiently.Private cost is the cost to producer or consumers only. External Cost refers to the cost to third party. Social cost is the sum of private cost and external cost.The price of a good reflects the value consumers place on consuming each unit of a good. The Marginal Cost is the full cost society has to pay to produce each unit of a good.

If Price > MC more of the good will be produced and as each unit is consumed the value reduces and the cost increases until Price = MC. If Price < MC then less of the good will be produced and the value of the last unit produced and consumed will be greater and the cost of production will be less until Price = MC. Therefore there will be production and consumption adjustments until Price = MC. As mostly private costs and benefits are involved therefore the market equilibrium is at the Social Optimum and P= MSC (Marginal Social Cost).

Effect of Externality

Negative Externality results in misallocation of resources.The effect of actions of consumers and producers on third party are not taken into account. As a result the market Equilibrium is disrupted and Socially optimum level of output is not achieved. Suppose a paper manufacturing firm produced paper and at the same time it dumps the harmful waste in the nearby river. The cost incurred in utilizing the factors of production is less than the cost it has imposed by harming the environment. The true cost is not charged to consumers. If the firm is compelled to install waste treatment plant , then it will raise cost of production and this increased cost will pass to condumers in form of increased price. As a result demand will reduce due to increased price and resources will be allocated to other markets. Since, the firm does not pay the environmental costs of production prices are lower than the Social Optimum, quantity produced is higher than the Social Optimum and resource allocation to this market is higher than the Social Optimum.In this case there is a divergence between private costs and social costs.

Here private cost is the cost incurred in utilising factors of production and social cost is the cost imposed on society in the firm of pollution and private cost discussed above.

Allocative inefficiency will occur if private cost or benefit diverges from social cost or benefit. Where externalities exist the condition for allocative efficiency is that price = social marginal cost.To conclude when a negative externality occur the firm is not compelled to pay for the cost incurred on the society (due to negative externality) and thus it will over produce resulting in allocative inefficiency.