SL/HL IB Economics (Google Slides) [2]

2.8 Market Failure— Externalities and Common Pool Resources

Negative Production Externalities (Types of Market Failure) - Notes

Kognity 2.8.2 (Online Textbook) - HL/SL

IB Core Concept Standard Level and Higher Level Concept

Market failure After studying this section, you will be able to:

● I can define all the terms appearing in orange highlights in the text.

● I can explain the concepts of negative externalities of production, and

the welfare loss associated with the production of a good or service.

● I can draw a diagram illustrating negative externalities of production and

welfare loss.

● I can explain policies available to governments in response to negative

externalities of production.

● I can evaluate policies available to governments in response to negative

externalities of production.

● I can draw diagrams to illustrate the policies available to governments in

response to negative externalities of production.

WHAT ARE NEGATIVE EXTERNALITIES OF PRODUCTION?

● Negative Production Externality: Refers to a situation where the production of a good or

service generates a negative effect on a third party (or society), which has not been factored into
the costs of producing the good.

➔ Note!: This usually happens when there is a negative impact on the environment caused
by a good being produced. This may be air or water pollution as a result of the production
process, loud noises generated while producing, or any other negative side-effects of
production activities that spill over onto society and are not accounted for in the private
costs for the firm.

Important!

When there is a negative production externality, the free market overallocates resources
to the production of the good, and too much of it is produced relative to what is socially

1
 optimum. This is shown by the quantity Qm > Qopt and MSC > MSB at Qm.

WHAT IS AN EXAMPLE OF A NEGATIVE PRODUCTION EXTERNALITY?

● Any negative effect of production on third parties that brings them costs is considered a negative
production externality.

➔ To see how this works, take the example of a firm that pollutes the air when producing
electricity, in which there are additional costs that spill over onto society due to the
polluted air, including respiratory illness and premature death that are not accounted for
in the private costs for the firm.

■ As shown in the diagram above, when this happens, the total cost of production for
society (MSC) is greater than the private cost (MPC), for every level of output. This
is because the supply of electricity does not take into consideration the negative
external effects it has on society as a whole, but only the costs to the private firm
that produces it.

■ Therefore, the vertical difference between MSC and MPC represents the negative
externality (harmful effect on society). This includes the harmful effects of air
pollution, including respiratory problems, certain types of cancer, and other health
problems.

■ In the example of electricity, society produces an amount Qm and sells it at a price

Pm. However, from the society's point of view, the optimum amount of electricity
produced should be at the point where the MSC curve intersects the MSB curve),
at Qopt.

2
 ■ Therefore, more resources are allocated to the production of this good than what is
optimal for society (Qm > Qopt). The market over-allocates resources to the
production of electricity.

■ The yellow-shaded triangle shows a welfare loss – net ‘dollar’ value lost by society
from the production of units Qm being produced by the market even though they
should have been from society’s point of view. This area of loss is equal to the
difference between the MSB and MSC curves for the amount of output that is
overproduced relative to the social optimum (Qopt − Qm). It involves external
costs for society that are lost because too much electricity is produced at too low of
a price. This is why it is a market failure.

HOW CAN THE GOVERNMENT REDUCE OR ELIMINATE THE WELFARE LOSS RELATED
TO NEGATIVE EXTERNALITIES OF PRODUCTION?

● To solve the problem caused by negative production externalities, the goal is to eliminate welfare
loss by reducing the quantity produced of the good until Qm reaches Qopt. There are several
possible ways in which the government can intervene to achieve this outcome:

➔ Impose a tax on emissions – The government could impose an indirect tax on each
ton of a pollutant emitted during the production process. The purpose of the policy is to
reduce the amount of a specific pollutant (ie, carbon, methane, or sulfur dioxide) emitted
by producers in the production process since these pollutants impose costs on to third
parties. In this case, the tax on emission is calculated on the basis of how much pollution
the firm emits: the more pollution emitted, the higher the tax, and the higher the private
costs of production. To understand this, take the example of electricity production that
burns fossil fuels, such as coal or natural gas, and in doing so, they create external costs.
In the case of a carbon tax, a government may impose a tax per ton of carbon dioxide
emitted during production.

Figure 1. Figure 2.

3
■ As shown in Figure 1, an indirect tax has the effect of shifting the supply curve of
carbon-based electricity production vertically upwards from S1 = MPC to S2 (= MPC
+ carbon tax).

■ The new market equilibrium is determined by the demand curve D = MPB and the
new supply curve S2 (= MPC + carbon tax), so the price paid by consumers for
electricity increases to Pc.

■ At the higher price (Pc), electricity consumption is now less affordable, so

consumers are incentivized to decrease the quantity of electricity consumed from
quantity Qm to Qopt.

■ Whereas producers of electricity receive from consumers Pc per pack, they must
pay the government Pc − Pp per kilowatt-hour of electricity produced (tax per
unit). Therefore, Pp is the final price received by producers the tax has been paid.

■ At the lower price (Pp), electricity production is now less profitable, so producers
are incentivized to decrease their quantity of electricity produced to quantity Qm
to Qopt.

■ If the tax equals the external cost, the S2 (= MPC + tax) curve intersects MPB at the
social optimum output, with production occurring at Qopt, reflecting allocative
efficiency.

■ The government receives tax revenue from the tax per kilowatt-hour of electricity
produced, given by (Pc − Pp) × Qopt, or the amount of tax per unit times the
number of units sold; this is the shaded area in the diagrams above.

■ Whereas a tax on emission is intended to achieve particular objectives, it does not

always work as expected:
4
Table 1. The strengths and limitations of a tax on emissions:

Advantages (of policy)

‒ Firstly, a tax on emissions can internalize negative externalities by

incorporating the social costs of electricity generation into the market price.
When electricity is produced through methods that generate negative
externalities, such as air pollution or greenhouse gas emissions, these costs
are not typically reflected in the market price. By imposing an indirect tax,
the government aims to align the private cost of production with the social
cost, ensuring that producers account for the externalities they impose on
society.

‒ Additionally, if a power plant emits pollutants that harm public health or

contribute to climate change, the tax on emissions would increase the cost
of electricity production from such sources. This encourages producers to
shift towards cleaner and more environmentally friendly methods of
electricity generation, such as renewable energy sources. The tax
incentivizes a reduction in negative externalities, promotes sustainable
practices, and contributes to a more socially responsible and
environmentally friendly energy sector. This is shown in Figure 2, in which
in the long-run, a tax on carbon emissions has the effect of shifting the MSC
curve from MSC1 to MSC2, indicating that the external costs are lower due
to the use of less polluting resources. With the fall in external costs, the
optimum quantity of output increases from Qopt1 to Qopt2.

‒ Finally, the government gains tax revenue equal to area (Pc - Pp) x Qopt.
Tax revenues from the tax on emissions can be invested in promoting
innovation and new technologies, such as renewable sources of producing
energy.

Limitations (of policy)

‒ There are a number of difficulties in this approach. The first involves

difficulties in measuring the value of the external costs. Take, for example,
the case of air pollution or greenhouse gas emissions caused by production
processes, which creates external costs. There are many technical
difficulties involved in trying to assess who and what is affected, as well as
determine the value of the external costs, on the basis of which a tax can be
designed (for the tax to eliminate the externality, the ideal size of the tax
should be equal to the external costs that are imposed onto society).

5
 ‒ Additionally, industries (producers) that use fossil fuels may oppose this
policy since carbon taxes make production less profitable and result in a
fall in revenue. When governments have tried to implement taxes on
emissions taxations, large companies have used their lobbying power and
legal teams to pressure the government to set the tax on emissions too low,
thus weakening the policy and the incentives to switch to less polluting
technologies.

‒ Carbon taxes are very regressive (less equitable). Poor families must pay a
higher proportion of their incomes to cover their electric bills. So any tax
targeting fossil fuels will be felt more by the poor than the rich.

Important!

In practice, given the limitations above for all the various policies, the most that
can be hoped for is a shift of the MPC curve toward the MSC curve, as well some
reduction in the size of the externality, but it is unlikely that these policies can
achieve the optimal results.

➔ Government regulation – The government could pass laws relating to environmental

standards that firms must comply with that limit their production activities that create
negative production externalities. The purpose of this policy is to prevent or limit
producer activities that impose costs on third parties, such as restrictions on emissions of
pollutants from factories and industrial production by setting a maximum level of
pollutants permitted, or requirements for steel mills and electricity generating plants to
install smokestack scrubbers to reduce emissions. This is known as a “command and
control” approach. To understand this, take the example of a government imposing
requirements that firms install non-polluting technologies that limit the amount of
pollutant parts per million released into the air.

6
■ As shown in the diagram above, regulations have the effect of shifting the S1 = MPC
curve (due to the firm’s higher costs of production due to the purchase of less
polluting or non-polluting technologies) towards the MSC curve until S2 overlaps
with MSC.

■ If the regulation is effective, the S2 (= MPC) curve intersects the MPB curve at the
social optimum output, with production occurring at Qopt, reflecting allocative
efficiency.

■ Whereas a regulation is intended to achieve particular objectives, it does not

always work as expected:

Table 2. The strengths and limitations of government regulations:

Strengths (of policy)

‒ Firstly, regulations have the advantage that they are simple to put into effect
and oversee. They are easier to implement compared to market-based
policies and avoid the technical difficulties that arise in the use of
market-based solutions.

‒ Additionally, regulations can set emission standards and environmental

targets, mitigating the negative impact of pollution and greenhouse gas
emissions from electricity generation. This helps protect ecosystems,
biodiversity, and public health. This may be achieved by the government
mandating polluting firms must invest in technologies and practices that
reduce their negative externalities. This often involves the purchase and
installation of pollution control equipment, the implementation of cleaner

7
 production processes, or the adoption of renewable and cleaner energy
sources. These changes result in direct costs for the firms. Additionally,
polluting firms may also face financial consequences such as penalties and
fines if they fail to comply with emission standards or other environmental
regulations, adding to their overall production costs.

Limitations (of policy)

‒ There are a number of difficulties in this approach. The first involves

difficulties in measuring the value of the external costs. In this case, the
government may lack sufficient technical information on the effects of
production externalities that cause environmental damage. This inevitably
results in over-regulation in some areas and under-regulation in others. For
example, to meet the standards, the firms would have to spend money to
comply with the regulation. If the costs are too high, firms may go out of
business, leading to unemployment and loss of services. Conversely,
under-regulations means that it may be cheaper for the firm to continue to
pollute (possibly pay a fine), rather than spending huge funds retooling the
production plant to reduce pollution.

‒ Additionally, regulations may also be met with intense opposition from

producers who may lobby the government to prevent them from bringing in
new legislation. For example, when governments have tried to implement
new legislation that impose higher costs of production by requiring firms to
comply with environmental standards, those industries affected by the
legislation may use their lobbying power and legal teams to prevent them
from doing so.

‒ Furthermore, regulations may also be difficult to enforce; it will be

necessary for the government to allocate resources to ensure that
stakeholders comply with regulations, and have mechanisms in place to
punish those who do not comply. This may impose an additional cost on
the government.

Important!

In practice, given the limitations above for all the various policies, the most that
can be hoped for is a shift of the MPC curve toward the MSC curve, as well some
reduction in the size of the externality, but it is unlikely that these policies can
achieve the optimal results.

8
➔ Tradable permits – The government could set up a tradable permit scheme which
establishes a cap (maximum) on the total amount of a specific pollutant that can be
emitted within a given period of time (usually a year). The purpose of the policy is to
reduce the amount of a specific pollutant (ie, carbon, methane, or sulfur dioxide) emitted
by producers in the production process since these pollutants impose costs on to third
parties. In this case, the total pollution that is permitted based on the pollution permits
must be less than the amount of pollution created with no permits. To see how this works,
take the example of a number of firms whose production pollutes the environment. The
government grants each firm a particular number of permits (or rights) to produce a
particular level of pollutants over a given time period. The permits to pollute can be
bought and sold among interested firms, with the price of permits being determined by
supply and demand. If a firm can produce its product by emitting a lower level of
pollutants than the level set by its permits, it can sell its extra permits in the market. If a
firm needs to emit more pollutants than the level set by its permits, it can buy more
permits in the market.

Figure 1. Figure 2.

■ As shown in Figure 1, the supply of permits is perfectly inelastic (ie, the supply
curve is vertical), as it is fixed at a particular level by the government. For this
policy to effectively reduce the level of pollution, the total pollution that is
permitted based on the pollution permits must be less than the amount of
pollution created with no permits. The fixed supply of permits is distributed to
firms.

■ The position of the demand-for-permits curve determines the equilibrium price.

As an economy grows and the firms increase their levels of output, the demand for
9
 permits is likely to increase, as shown by the rightward shift of the demand curve
from D1 to D2.

■ However, with the supply of permits fixed at quantity Q1, an increase in demand
for permits results in the price of permits to increase from P1 to P2.

■ As shown in Figure 2, the effect is to shift the S1 = MPC curve (due the increase in
price of permits) towards the MSC curve until S2 overlaps with MSC.

■ If the tradable permit scheme is effective, the S2 (= MPC) curve intersects the MPB
curve at the social optimum output, with production occurring at Qopt, reflecting
allocative efficiency.

■ Whereas a regulation is intended to achieve particular objectives, it does not

always work as expected:

Table 3. The strengths and limitations of tradable permit schemes:

Strengths (of policy)

‒ Firstly, a tradeable permit scheme can internalize negative externalities by

incorporating the social costs of electricity generation into the market price.
When electricity is produced through methods that generate negative
externalities, such as air pollution or greenhouse gas emissions, these costs
are not typically reflected in the market price. By imposing an indirect tax,
the government aims to align the private cost of production with the social
cost, ensuring that producers account for the externalities they impose on
society.

‒ Additionally, if a power plant emits pollutants that harm public health or

contribute to climate change, the permit scheme would increase the cost of
electricity production from such sources. This encourages producers to shift
towards cleaner and more environmentally friendly methods of electricity
generation, such as renewable energy sources. The scheme incentivizes a
reduction in negative externalities, promotes sustainable practices, and
contributes to a more socially responsible and environmentally friendly
energy sector. This is shown in Figure 2 (tax on emissions), in which in the
long-run, a tax on carbon emissions has the effect of shifting the MSC curve
from MSC1 to MSC2, indicating that the external costs are lower due to the
use of less polluting resources. With the fall in external costs, the optimum
quantity of output increases from Qopt1 to Qopt2.

‒ Furthermore, the scheme creates incentives for firms to cut back on their
pollution if they can do so at relatively low cost. If it is a relatively low-cost

10
 procedure for a firm to reduce its pollutant emissions, it will be in its
interests to do so and sell excess permits. Firms that can only reduce
pollution at high cost will be forced to buy additional permits. Therefore,
both taxes and tradable permits are methods to reduce pollution more
efficiently (at a lower cost).

Limitations (of policy)

‒ There are a number of difficulties in this approach. The first involves

difficulties regarding information on types and amounts of pollutants
emitted. There are many technical difficulties involved in trying to assess
who and what is affected, as well as determine the value of the external
costs. For this policy to effectively reduce the level of pollution, the total
pollution that is permitted based on the pollution permits must be less
than the amount of pollution created with no permits.

‒ Additionally, tradable permits require the government to set a maximum

acceptable level for each type of pollutant, called a ‘cap’. This task demands
having technical information on quantities of each pollutant that are
acceptable from an environmental point of view, which is often not
available. If the maximum level is set too high, it will not have the desired
effect on cutting pollution levels. If it is set too low, the permits become
very costly, causing hardship for firms that need to buy them.

‒ Furthermore, tradable permit schemes face political pressures to set the cap
too high. If the cap on pollutants is set too high, it would have a very
limited or no impact on reducing air pollution or greenhouse gas emissions.

‒ Finally, a method must be found to distribute permits to polluting firms in

a fair way. Issues of political favoritism may come into play, as governments
give preferential treatment to their ‘friends’ and supporters.

Important!

In practice, given the limitations above for all the various policies, the most that
can be hoped for is a shift of the MPC curve toward the MSC curve, as well some
reduction in the size of the externality, but it is unlikely that these policies can

11
achieve the optimal results.

12
‒ In the case of emissions of pollutants, they do not offer incentives to reduce emissions, to increase
energy efficiency, and to switch to alternative non-polluting technologies; and they cannot
distinguish between high- and low-cost polluters, which would limit the overall cost of reducing
pollution.

13