Question

How can markets results in efficient outcomes even in the presence of negative externalities and government intervention? Explain clearly!

Answer 1

The economic efficiency occurs when marginal benefit from an economic activity is equal to its marginal cost. The two criteria for economic efficiency are:

1. If an economic activity produces more benefit than its cost, then the activity is said to be economically efficient.
2. If an economic activity produces less benefit than its cost, then the activity is said to be economically inefficient.

To produce an economic efficient outcome both of the above criteria has to be satisfied.

If the spillover effect from any economic activity influence the wellbeing of a third party not involved in an activity is called the externality. There are two types of externality: external cost and external benefit. If the externality benefits the third party there will be external benefit and if it imposes a cost to third party it will be external cost.

In case of external cost, the market allocation will be greater than the social optimum. The factory that emits their toxic waste at a river nearby will destroy the fish in the river. The nearby fisheries will incur the cost in terms of decreased production. Thus, the cost to the society is greater than the production cost of the factory. Therefore, the factory tends to overproduce the goods that are socially optima. Hence, the market fails to allocate the resource optimally.

There are three government solutions to externality. They are taxes or subsidies, command and control, and tradable allowances. If the best approach to a problem is well known and if success requires very strong compliance the command and control is the method to control externality. If it’s important to control the externality at the least possible cost and if the government does not have full information then the taxes or subsidy method is adopted.

Let us consider the resource allocation of a hypothetical industry: paper industry. The paper industry generates pollution and thus imposes social cost on the society.  

The above figure shows the market equilibrium for paper. The market equilibrium maximizes consumers’ surplus plus producers’ surplus. At equilibrium the price of the paper is $10 and in the market Q_Market is sold at that price. But the paper creates external cost. Suppose that the external cost of paper is $10. Private cost plus external cost is the social cost. The social cost of paper is $20 for the equilibrium quantity that prevails in the market. In the figure we add external cost to the private supply curve to find the social cost of the paper. Thus, in the figure the social supply curve gives the social cost of paper. The efficient quantity that maximizes social surplus is found at the point of intersection between social supply curve and the private demand curve. It is given by Q_Efficient, the true social cost of the papers is $15.

The government should tax the paper by the amount of external cost to include the externality in price. This will produce the social optimum outcome. The revenue which the government would collect can be used in various purposes. The government already included the cost of harmful effects on the price of paper. Then again spending the revenue again to fix the harmful effect will be double spending for the same cause.