Negative externalities of production

When the production process of a good or service generates a negative effect on a third party or on
society, we say that there is a negative externality of production.
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 because 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.
Any negative effect of production on third parties that brings them costs is considered a negative
externality of production.

Figure 1. Air pollution caused by harmful emissions from factories.

Credit: Getty Images kodda

When this happens, the marginal social cost of production (MSC) is greater than the private cost
of production (MPC), as firms do not take these extra costs into consideration when deciding how
much to supply at each price level. This results in a greater amount of the goods being produced than
the socially optimal output, and therefore an over-allocation of resources to the production of such
goods from society’s point of view.
Look at the example in Figure 2. It shows the situation of a firm that pollutes the air when producing
steel. Coke is a coal-based substance used in the production of steel, and its manufacturing is a
significant contributor to air pollution. Steel making also requires a lot of energy, much of which will
be produced by the burning of fossil fuels. China has in recent years struggled to balance the demand
for steel for its growing economy against the need to place limits on the pollution for which this
industry is responsible.

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Through the forces of demand and supply, only taking into consideration the firm's private costs of
production (MPC) and the private benefit of consumption (MPB), the market will end up producing at
the point where the quantity supplied is equal to the quantity demanded of steel, Q2.

Figure 2. Production of steel while polluting the air.

Be aware
This type of externality involves only the production side of the market (the supply curve). The
demand curve represents both the marginal private benefit (MPB) and marginal social benefit (MSB)
of consuming the good, so here MPB = MSB.
As seen in Figure 2, the total cost of production for society (MSC) is greater than the private cost
(MPC), for every level of output. The vertical difference between MSC and MPC represents the
negative externality. The optimum amount of steel produced, from the society's point of view, should
be at the point where the MSC curve crosses the demand curve (the MSB curve), at Q*.
As the cost of producing steel is greater for society than for the private firm, the market outcome
results in a greater amount of steel produced than what should be produced if the total social costs of
production were taken into consideration – in other words, if the pollution caused by the firm is not
internalized (see Possible government responses, below, for more on internalization).

Important
When there is a negative externality of production, the amount produced is greater than it should be,
from society’s point of view. Therefore, more resources are allocated to the production of this good
than what is optimal for society. The market over-allocates resources to the production of the good.

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In the example of steel, society produces an amount Q2 > Q* and sells it at a lower price, P2 < P*.
Therefore, there is an inefficient allocation of resources from society's point of view. A welfare loss –
the amount of welfare society loses through allocative inefficiency – is shown by the yellow shaded
triangle in Figure 2. All the units produced from Q* to Q2 have a higher cost for society than the
benefit they bring to it (MSC > MSB). This is why it is a market failure.

Exam tip
Students often confuse the position of the MSC curve with respect to the MPC curve. Remember that
a 'higher social cost' means a 'lower socially optimum supply' and therefore the MSC should be above
(to the left of) the MPC.
Possible government responses
In a free market, these negative externalities of production would continue to exist because firms are
profit maximisers and will only take their private costs of production into account. However, there are
several possible ways in which the government can intervene to solve or reduce the externality.
To solve the problem caused by negative externalities of production, the goal is to eliminate the
welfare loss by reducing the quantity produced of the good until Q1 reaches Q*.
The solutions below aim to make the contaminating firms internalize – meaning they absorb – part
of the cost they are generating for society, or to prevent firms from using polluting methods of
production. This can be done through different options:
• Imposing a carbon tax on polluting firms
• Legislation
• Tradable emission permits
Solutions to negative externalities of production.
Imposing a carbon tax on polluting firms
The government could impose a tax on the firm per unit of output produced, or a tax per unit of
pollutants emitted, to increase the private costs of production. Have a look at this CBS News website ,
https://www.cbsnews.com/news/carbon-tax-hot-stuff-heres-how-they-would-work/
which gives a lot of information about carbon taxes and discussion of how they might be implemented
in the US. You can also look here https://www.carbontax.org/where-carbon-is-taxed-overview/,
to see where carbon taxes have been imposed.

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www.mashrek.edu.jo [email protected]
The tax results in an upward shift of the supply curve from MPC to MPC + tax, nearer to the point of
social efficiency. If the tax is equal to the external cost of production, then the externality would be
internalized. If not, although the welfare loss for society would be reduced, it would not be eliminated
completely. There is still a welfare loss, but it will be less than with no government intervention at all.

Benefits of this solution:

• Carbon taxes on polluting firms are much easier to apply than other measures, such as
tradable emission permits.
• Tax revenues from carbon tax will be collected and can be invested in promoting innovation
and new technologies, such as renewable sources of producing energy.

Problems with this solution:

• It is often difficult to measure the pollution created and put a value on it to establish the
amount of the tax.
• It is also difficult to identify which firms are polluting and to what extent each firm is
responsible for the pollution.
• Taxes make firms pay for the pollution they create but do not actually stop the pollution from
taking place.

Legislation
The government could pass laws relating to environmental standards that firms must comply with in
the production process, such as using specific types of machinery, air filters, water processes and
disposal methods. To meet these standards, a firm's cost of production would increase, shifting the
supply curve upwards.
In this case, the effect on the market outcome would be like the one of taxes, as the MPC would
increase nearer to the MSC, reducing the externality and hence the welfare loss for society. In the case
of companies breaching the environmental legislation, the costs for cleaning the pollution created are
passed on to the polluting company and thus internalized. For example, in 2017, the UK
Environmental Agency imposed fines to major polluting firms such as Heineken UK, Filippo Berio
and others.
An extreme intervention could also be to ban polluting firms altogether.
Problems with this solution:
• The ban or restriction may lead to unemployment in the corresponding industry, as jobs
would be lost if firms are closed or the market reduced.

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 • Banning a firm would create non-consumption of the goods that were being produced, which
might be a good necessary or desirable to consumers.
• The cost of setting and then enforcing the policy standards may be very difficult to
implement, and/or have a greater cost than the pollution itself.

Tradable emission permits

This type of solution was agreed upon in the Kyoto Protocol, made under the United Nations
Framework Convention on Climate Change, which came into force in February 2005. The objective
was to reduce the global emission of greenhouse gases. In this example, the agreement was between
countries, but a similar procedure could be applied to individual market cases. Look at Figure 4 to see
which countries currently employ emissions trading schemes.

Source: "World Bank" is licensed under CC BY 3.0 IGO

Figure 4. A map showing the carbon taxes and emissions trading schemes employed in various
countries.

The government sets the level of 'admitted pollution' per year and splits the 'permission to pollute' into
several tradable emission permits. These are allocated to individual firms, which now have a quota
of emissions that they are allowed to produce. Firms that pollute less can sell their remaining quota to
other firms who need to pollute more. This is why they are called 'tradable'.

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Benefits of this solution:
• It encourages firms to seek lower-cost methods of reducing emissions, such as better energy
efficiency, which will lower their overall production costs.
• It helps achieve the environmental objective of reduced emissions at lower costs.
• The price of permits is determined by the free market, which allows greater flexibility to
firms, because in a period of recession the price will fall due to falling output and in periods
of economic boom the price will rise. This flexibility will allow firms to benefit from
reducing emissions.
• It provides a way for international cooperation to tackle the global challenge of emissions.

Problems with this solution:

• To start with, it is difficult to set an acceptable level of pollution.
• It is also difficult to measure a firm's pollution production in order to establish the number of
permits per firm.
• Firms pay for the pollution they create but it does not lead to a reduction in pollution once the
allowed limit has been set.

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www.mashrek.edu.jo [email protected]