Question

2. (a) Define a negative externality. (b) Is there any evidence for the claim that “fraging” for natural gas generates a negative externality. (c) Use a graph for the natural gas market and assume there is a relatively constant cost in the long run at $4 per cubic foot. Suppose there is a negative externality of $2 per cubic foot. Briefly explain how negative externalities distort otherwise well-functioning competitive markets and lead to market failure. (d) Briefly describe the impact of the imposition of a Pigouvian tax on natural gas that might resolve the market failure due to negative externalities.

Answer 1

a.

Negative externality is cost as a result of an economic transaction which is suffered by a third party outside of the transaction. It occurs when production or consumption decision imposes external cost on a third party outside the market. A negative externality has a bad effect on people. This cause social costs to exceed private costs.

b. fracking for natural gas generates a negative externality. There are various studies which prove the side effects of fracking for natural gas. The harmful effects are given below.

1) Groundwater contamination in the immediate neighbourhood of wells

2) Contamination of aquifers on a wider, regional scale

3) Harmful effects on health of undisclosed components of fracturing fluids

4) Blowouts, house explosions and flaming kitchen faucets

c.

Market failure is a situation where the allocations of goods & services is not efficient. It leads to a social welfare loss. When negative externality is present it means that producer does not bear all the costs resulting from excess production. Externalities result in market failures because price equilibrium does not accurately reflect the true costs & benefits of a product. In the real world it is not possible for markets to be perfect due to inefficient productions & negative externalities. In the case of negative externalities, third parties experience harmful effects from an economic transaction in which they are not involved. In order to compensate for negative externalities, the market as a whole is forced to reduce its profits in order to repair the damage that was caused, which decreases efficiency.