The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production. Production decisions are generally based on financial data and most social costs are not measured that way. For example, when a firm decides to open up a new factory, it will not account for the cost that residents accrue by drinking water from a river the factory polluted.
In other words, the costs of production represent individual, or private, marginal costs. The private marginal costs are lower than societal marginal costs, which also capture the true costs of the negative externalities.
As a result, producers will overestimate the ideal quantity of the good to produce. Negative Externality : Graphically, negative externalities occur when social costs are lower than private costs, and firms produce more units than is socially optimal.
The ideal equilibrium quantity that reflects negative externalities is Qs, but firms may produce at Qp. Governments can either use regulation e. By instituting policies such as pollution penalties, permitting civil lawsuits by private parties to recover damages for negligent actions, and levying environmental taxes, governments can achieve two things.
First, these regulations recover funds to help fix the damage caused by negative externalities. Pollution is another commonly known negative externality. Corporations and industries may try to curb their costs by putting in production measures that may have a detrimental effect on the environment.
While this may decrease the cost of production and increase revenues, it also has a cost to the environment as well as society. Meanwhile, establishing more green spaces in a community brings more benefit to those living there. Another positive externality is the investment in education.
When education is easy to access and affordable, society benefits as a whole. People are able to command higher wages, while employers have a labor pool that's knowledgeable and trained. Governments may choose to remove or reduce negative externalities through taxation and regulation, so heavy pollutants, for example, may be taxed and subject to more scrutiny.
Those who create positive externalities, on the other hand, may be rewarded with subsidies. Externalities lead to market failure because a product or service's price equilibrium does not accurately reflect the true costs and benefits of that product or service.
Equilibrium, which represents the ideal balance between buyers' benefits and producers' costs, is supposed to result in the optimal level of production.
However, the equilibrium level is flawed when there are significant externalities, creating incentives that drive individual actors to make decisions which end up making the group worse off. This is known as a market failure. When negative externalities are present, it means the producer does not bear all costs, which results in excess production. With positive externalities, the buyer does not get all the benefits of the good, resulting in decreased production.
Let's look at a negative externality example of a factory that produces widgets. Remember, it pollutes the environment during the production process.
The cost of the pollution is not borne by the factory, but instead shared by society. If the negative externality is taken into account, then the cost of the widget would be higher. This would result in decreased production and a more efficient equilibrium.
In this case, the market failure would be too much production and a price that didn't match the true cost of production, as well as high levels of pollution. Now let's take a a look at the relationship between positive externalities like education and market failure. Obviously, the person being educated benefits and pays for this cost. Another asymmetric information problem is moral hazard.
Moral hazard occurs when the behavior of one changes after the contract is made. For example, those who purchase insurance may be less inclined to take precautions after the purchase, knowing that they are insured.
This may be the case, even if the borrower is a stellar customer and has never carried a balance on the credit cards, because of the potential that a large amount of credit could easily be obtained. However, after paying the claim, the insurance had the man arrested and charged with 24 counts of arson after he cashed the check.
Country singer Brad Paisley summarize what happens in the song, The Cigar. A variety of methods both private and public can help to address these problems all designed to gather information that the other party knows. Health insurance companies, for example, typically have individuals fill out a health history and complete a physical exam to determine the premiums they will charge to the individual.
Credit scores can also help companies assess the likelihood of individuals repaying their loans and allow them to charge an appropriate interest rate. Those with good credit scores get better rates, while those who have not managed their finances appropriately in the past are charged a higher rate.
Credit scores are also used in other areas, such as car insurance, since individuals who are irresponsible with their finances have a higher likelihood of being irresponsible in other behaviors as well. Deductibles are designed to prevent the problem of moral hazard. If individuals have to bear at least a portion of the cost when they make an insurance claim, they are less likely to make a claim.
Furthermore, the threat of having increased premiums or being dropped by the insurance company, can be a deterrent from moral hazard. Product reports and reviews also provide information to help individuals make an informed decision. Publications such as Consumers Report are an independent review of products ranging from cars to washing machines.
Movie reviews can be beneficial to individuals trying to make an informed decision about the content of a movie and what to watch. Consumers are also more willing to purchase goods that offer warranties or money back guarantees. Many consumers often have the perception that products with good warranties are better.
While this is not necessarily the case, it reduces the risk associated with purchasing the good. Even though a product may offer a warranty, there is a cost associated with returning the defective product and keeping the necessary paperwork to have the firm honor the warranty.
Franchises are another way firms employ to address asymmetric information. Restaurant chains, for example, strive to have a relatively consistent product at each location. Thus if you are visiting a new city, you know what to expect if you go to a national restaurant chain. Government has set various standards to insure a minimum quality ranging from food products, such as grade A milk, to bar exams to insure that individuals practicing law have some minimum competency.
Some professions require that individuals receive additional training in their respective profession annually to maintain their license. Inspections also promote confidence in what is being purchased. For example when filling your car up with gas, we trust that we are receiving not only the quality but also the quantity of what is indicated on the pump, because the Department of Weights and Measures has indicated that the pump has been checked and approved.
Various laws restrict certain activities such as insider trading. Individuals within a company are restricted from selling their stock due to information they know about the company, prior to the information being released publically.
The government also may also publish reports disclosing specific information about an industry, such as accident and death rates. This allows individuals considering an industry to know more of the potential risks of the industry.
In addition, agencies such as the Occupational Safety and Health Administration OSHA require businesses to provide certain working conditions and impose fines when the firms are not in compliance. While government plays a role in correcting certain market failures, they may not solve the problem for several reasons:. Principal-agent problem. Thus, he has the incentive to grow the welfare program so his position is more important with a larger budget. If the goal of a politician is to get reelected, he may pursue policies that are politically popular but impose additional costs on society at some later time period.
The growing national debt, is evidence, that politicians would rather spend today and force some future generation to pay for it. Government may fail to recognize and account for the unintended consequences of their actions.
Earlier we mentioned, flood insurance that was designed to provide affordable insurance to those in flood prone areas. However, the subsidized insurance has lead to additional people building in areas that are flood prone, due to the government subsidy.
Given the bureaucratic nature of government, government intervention generally takes longer and costs more than originally anticipated. More intervention leads to more laws and more administrative bodies to enforce those laws, which adds additional costs to the tax payers. Furthermore, many of the issues government addresses are large and complex in nature with many unknown factors, making it difficult to pass a meaningful effective bill that focuses on the problem.
Regulatory Capture is another potential government failure when the regulatory agency acts in the interest of those it is assigned to regulate. This is used to present users with ads that are relevant to them according to the user profile. The cookie is used for recognizing the browser or device when users return to their site or one of their partner's site. This cookie registers a unique ID used to identify a visitor on their revisit inorder to serve them targeted ads.
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