<NEGATIVE PRODUCTION EXTERNALITIES>

• A NEGATIVE EXTERNALITY OF PRODUCTION occurs when an INDIVIDUAL FIRM'S PRODUCTION PROCESS decreases the well-being (CREATES EXTERNAL COSTS) of others (THIRD PARTIES) to whom they fail to COMPENSATE.

• There are basically TWO REASONS why DEMERIT GOODS are OVERPRODUCED:-

• • • FIRSTLY, if the PRODUCERS DO NOT NEED TO COMPENSATE (REIMBURSE) the third parties for the EXTERNAL COSTS then the COSTS OF PRODUCTION THEY FACE will be LOWER than the FULL COSTS TO SOCIETY. Therefore they will SUPPLY MORE ('OVERPRODUCE'), as well as CHARGE LOWER PRICES. 

• • • SECONDLY, because some of the CONSUMERS OF THESE PRODUCTS are IGNORANT (UNAWARE) about the FULL COST of the product's production to society, they will subsequently DEMAND MORE than they would if they had MORE AWARENESS.

• If in THE PROCESS OF PRODUCING a good, there are EXTERNAL COSTS to third parties that are NOT ACCOUNTED FOR IN THE PRODUCER'S COSTS OF PRODUCTION, then the PRODUCER'S SUPPLY CURVE only represents their PRIVATE COSTS (MPC) and therefore will not represent society's cost curve (MSC) which is equal to the PRIVATE COST PLUS THE EXTERNAL COST of this activity on society. 

• In other words, if we based the supply curve on the marginal costs society incurs per unit rather than the marginal costs incurred by private producers we will derive TWO SUPPLY CURVES, one representing society (MSC CURVE) and one representing the private producers (MPC CURVE) with the MPC curve more to the LEFT.

• IF WE ASSUME THE MSB CURVE IS FIXED then the equilibrium quantity transacted using the MSC curve is LESS THAN the equilibrium quantity transacted using the MPC curve.

• Hence the FREE MARKET OUTPUT (MSB = MPC) is GREATER THAN the SOCIALLY OPTIMAL AMOUNT (MSB = MSC).

• We can see in the diagram below, that the exclusion of external costs results in the producer's supply curve (MPC) being to the RIGHT, of the MSC curve, (MPC<MSC) leading to OVERPRODUCTION and a DWL.

• An individual producer's supply curve represents the MARGINAL PRIVATE COSTS (MPC) incurred during their own PRODUCTION PROCESS such as wages for labour and rent for premises, however, the use of carbon-emitting energy sources during this process creates EXTERNAL COSTS to 3rd parties (SOCIETY) in the form of CONTRIBUTING TO GLOBAL WARMING and all the associated third party effects, yet in a free-market, the producer DOES NOT NEED TO COMPENSATE society.

• If this external cost was to be incurred by the producer then their final costs of production would be higher and their MPC curve would be further to the LEFT, resulting in a HIGHER PRICE and a LOWER QUANTITY TRANSACTED and hence closer to the SOCIALLY OPTIMAL LEVEL (Closer to the MSC curve). 

• An individual commercial fishing boat's supply curve represents the MARGINAL PRIVATE COSTS (MPC) incurred during their own PRODUCTION PROCESS such as wages for labour, operating costs for the boat, licenses etc, however, when they FISH UNSUSTAINABLY it creates EXTERNAL COSTS to 3rd parties (SOCIETY) in the form of DEPLETED STOCKS FOR FUTURE GENERATIONS TO GLOBAL WARMING and all the associated third party effects, yet in a free-market, the producer DOES NOT NEED TO COMPENSATE society.

• If this EXTERNAL COST was added to the private costs of the fisherman their MPB CURVE will SHIFT LEFTWARDS closer to the MSC curve, raising prices and reducing the quantity produced to the SOCIALLY OPTIMAL LEVEL. 

• Farmers use fertilizers as part of the PRODUCTION PROCESS of many agricultural products to improve their crop yields. However, these CHEMICALS contain phosphorus which seeps into the rivers and leads to plant and algae growth that can kill fish. 

• This creates EXTERNAL COSTS in the form of DAMAGING THE ECOSYSTEM and DESTROYING THE MAIN FOOD and INCOME SOURCE for many people who rely on river fish for their food and livelihood.

• Farmers let their cattle graze in areas, that are usually free to use (CPRs), however, they have 3rd party effects as the land gradually degrades as the livestock walk back and forth eating all the vegetation which eventually leads to desertification of the land making it useless for growing. 

• LITTERING can also be considered THE IMPROPER DISPOSAL OF WASTE, hence both producers and consumers can be guilty of this.

• In the case of an individual producer, their supply curve represents the MARGINAL PRIVATE COSTS (MPC) incurred during their own PRODUCTION PROCESS such as wages for labour and rent for premises, however, THE IMPROPER DISPOSAL OF WASTE DURING THIS PRODUCTION PROCESS CREATES EXTERNAL COSTS to 3RD PARTIES (SOCIETY) in the form of PUBLIC HEALTH RISKS and the EXPENSE OF CLEANING UP LITTERED AREAS to name just two, yet in a free-market, the producer MAY AVOID NEEDING TO COMPENSATE SOCIETY and thus they are not reflected in the market price of the products being produced.

• If this external cost was to be incurred by the producer then their final costs of production would be higher and their MPC curve would be further to the LEFT, resulting in a HIGHER PRICE and a LOWER QUANTITY TRANSACTED and hence closer to the SOCIALLY OPTIMAL LEVEL (Closer to the MSC curve). 

• This example can feel odd as the problem arises way after the production and consumption process is finished.

• This external cost arises due to the fact that THE PRODUCTION OF ANY GOOD THAT REQUIRES DISPOSAL, and which ISN'T BIODEGRADABLE, such as SINGLE-USE PLASTICS, (STRAWS, BAGS),  and POLYSTYRENE, etc... will require some form of DISPOSAL, be it in LANDFILLS or AT SEA, which creates external costs in the form of ENVIRONMENTAL DAMAGE, HEALTH IMPACTS, COST of CLEANUPS, LOSS of TOURISM, ECOSYSTEMS, FISHING LIVELIHOODS, etc...

• Of course, the actual culprits can be individuals, firms, and even governments, however, this does not take away from the fact that the producers of these products, which all eventually need disposal do not have to pay for it. 

• Clearly, the socially optimal level of output ('Qso') is determined by the size of the EXTERNAL COST created by the production process NOT THE NUMBER OF UNITS PRODUCED, hence if the EXTERNAL COST can be reduced per unit then this would increase the socially optimal level.

• Therefore, unlike the INDIRECT TAX, which is IMPOSED ON EACH UNIT PRODUCED, THIS TAX IS IMPOSED ON EACH UNIT OF CARBON PRODUCED.

• Why is this better? Because as we know IT IS NOT THE PRODUCT THAT IS CREATING THE EXTERNAL COST, the problem is the PRODUCTION PROCESS therefore A CARBON TAX ATTEMPTS TO DISCOURAGE THE PROCESS RATHER THAN THE PRODUCT and therefore INCENTIVISE FIRMS TO SWITCH TO CLEANER METHODS OF PRODUCTION and this SHOULD RESULT IN GREATER CONSUMER SURPLUS.

• This has the following TWO IMPACTS:- 

  • • • Firstly, to avoid the tax firms will be incentivised to switch to cleaner fuels, therefore the average size of the external cost should fall. As such there is a new MSC curve based on the smaller external cost.

      • Secondly, like with an indirect tax on output, the private costs for the firms will increase as the lower carbon emissions they produce are still taxed meaning their private costs will rise and this will cause the MPC curve to shift leftwards.

• Broadly speaking, carbon taxes guarantee the price that companies must pay for emitting CO2, but they do not guarantee the environmental outcome – companies could simply pay the tax and continue emitting. By contrast, carbon trading systems guarantee the environmental outcome by setting a legally binding limit on CO2 emissions, but with moveable prices determined by the balance between supply and demand.

• Both systems have advantages and disadvantages. Carbon taxes offer certainty over what industry will have to pay for emitting CO2. This can be helpful when making investments that need to be profitable over a long time horizon. In particular, this certainty over cost can help when companies are seeking to borrow capital. And at an operational level, carbon taxes are generally simpler to administer than emissions trading systems.

• Emissions trading, on the other hand, has a unique advantage: a company that can cut CO2 emissions at a lower cost than the price of carbon allowances can sell its surplus allowances to others. This means that, unlike carbon taxes, emissions trading is not necessarily punitive: it can generate wealth as well as simply representing a cost burden.

• In this way, carbon trading systems harness market forces to drive emissions reductions at the lowest cost first, reducing the overall bill to meet the agreed emissions reduction target.

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• TRADEABLE PERMITS are a type of quota scheme, in that the government first decides on a MAXIMUM ALLOWABLE LEVEL OF EMISSIONS that factories are permitted to emit, called The 'CAP' (Which gets steadily reduced, usually annually) then DISTRIBUTES pollution permits/allowances (for example one permit per tonne of emissions) amongst the firms.

• Here comes the TRADE...

  • • If a firm finds it difficult or costly to reduce their emissions to stay within their allocated allowances and go ABOVE their permitted amount they will be FINED HEAVILY unless they can buy additional allowances from other emitters who have been successful in reducing their emissions below their allocated allowances and thus have surplus allowances.

    • This extra cost can only be reduced through lowering their pollution levels, and due to the ever-decreasing number of permits, this cost will continue to rise until a point where it is cost-effective to switch to cleaner emission reduction technology or simply leave the industry.

    • This competition drives innovation and encourages emitters to find efficient and cost-effective ways to reduce emissions to save money on allowances.

• This system creates a financial incentive for emitters to continually seek innovative solutions and invest in technology that can lead to a reduction in emissions, as it can save them money in the long run and help them stay within their emission limits.

• LINK

• REDUCING SMOKING EXAMPLE: Imagine that the government wished to reduce the amount of smoking to 100 per day and decided to do this over a 10-week period, reducing the total, from an initial 1000, by 100 each week. In the first week, they gave each smoker 10 x 1 cigarette permits each (assume 100 smokers), per day and told them that they would be put in jail for a very long time if they exceeded the number of cigarettes that their permits allowed without paying compensation. They were also told that they were allowed to trade them. What do you think will happen? Will the smokers only smoke a total of 1000?

• Those smokers who are less addicted and who can quickly and easily give up or reduce their smoking habit will do so as they will be incentivised to reduce their smokes to below 10 and 'auction off' their unused permits to the highest bidder from those smokers who are more addicted and who are unable to cope with only 10 per day. 

• With a fixed supply and such high demand, the price mechanism should cause the price of the permits to rise significantly, meaning the cost of smoking more than 10 will likely be more expensive than the cost of seeking professional help to give up.

• Heavy smokers will be forced to give up as the fall in supply will raise the prices even further.

TASK NOW APPLY THIS THINKING TO REDUCING CO2 EMISSIONS!

• MORE EFFICIENT STUDY EXAMPLE: Imagine that the school wished to improve the efficiency of students' study and reduce the wasted hours studied by students outside of school by setting an overall total of 1000 hours per week, then gave each student 10 x 1-hour permits each (assume 100 students), per week and told them that they would have to pay a fine if they studied more hours than their permits allowed. 

• They were also told that they were allowed to trade them. What do you think will happen? Will the students only study a total of 1000 hours per week? Will each student stick to their 10-hour permit exactly? 

• Those students who can quickly and easily change their study habits and become more efficient will do so as they will be incentivised to reduce their study hours below 10 and 'auction off' their unused permits to the highest bidder from those students who have really inefficient and inflexible study habits and who can't change in the short-term. 

• With a fixed supply and such high demand, the price mechanism should cause the price of the permits to rise significantly. This high cost will eventually lead to these inflexible students being incentivised to become more efficient to reduce this burden. 

• The net result should be the students adopting more efficient study habits.!

• REDUCE EXCESSIVE SCREENTIME EXAMPLE: Imagine that the government identified 'excessive screen time' as a demerit good, creating 3rd party costs to society, so it set an overall total of 1000 hours per week, then gave each student 10 x 1-hour permits each (assume 100 people), per week and told them that they would have to pay a fine if they viewed more hours than their permits allowed. 

• They were also told that they were allowed to trade them. What do you think will happen? Will the people only view a total of 1000 hours per week? Will each student stick to their 10-hour permit exactly? 

• Those people who use less than the allotted allowance or who are less addicted will now do so as they will be incentivised to reduce their hours below 10 and 'auction off' their unused permits to the highest bidder from those people who are more addicted and less flexible and who are unwilling to change in the short-term. 

• With a fixed supply and such high demand, the price mechanism should cause the price of the permits to rise significantly. This high cost will eventually lead to these inflexible individuals realising that is probably more costs effective to seek professional help or invest in other hobbies that donlt involve screentime.

• These approaches refer to when the government USES ITS AUTHORITY TO IMPLEMENT RULES AND LAWS aimed at REDUCING the OVERPRODUCTION. 

  • • • By REQUIRING FIRMS TO INSTALL NON-POLLUTING TECH. This will force firms to reduce the external cost directly and should have the same affect as the carbon tax, as it reduces the EC and shifts the MSC to the left, as well as increases MPC (The cost of the new tech will increase costs) shifting it to the right.

      • By PLACING A QUOTA ON THE AMOUNT THAT CAN BE PRODUCED to restrict output to the desired level. Such as for logging, hunting, and fishing.

      • By REQUIRING PRODUCERS TO OBTAIN LICENSES in order to control numbers, such as fishing and hunting licenses.

      • By MAKING AREAS PROTECTED from any exploitation.

      • By BANNING production completely.

• How does the above quote from Nobel-prize winner Elinor Ostrom relate to the concept of collective-self-governance and why does the concept have limited applicability, in particular for oceans?

• CAP & TRADE systems are another type of market-based scheme that aims to INCENTIVISE producers to switch to cleaner production processes.

  • • 1. Firstly the gov't decides on a MAXIMUM ALLOWABLE AMOUNT OF EMISSIONS (This is referred to as the 'CAP')

    • 2. Next they DIVIDE UP THIS CAP AMOUNT INTO PERMITS which each allow a certain amount of emissions (e.g. 1 permit per 100 tonnes of CO2)

    • 3. They DISTRIBUTE THEM TO the polluting firms.

    • 4. You have 10 permits this week

• The trading system establishes a maximum allowable amount of pollution, a cap, that can be released. This cap is the total amount of a particular pollutant that can be emitted by everyone in a particular jurisdiction (a province, a state, a country, or even a group of jurisdictions). The cap is divided into permits which are distributed to firms that emit pollutants (mercury, carbon monoxide, NOx, etc.). This permit states that the owner of the permit can emit a certain amount of the given pollutant. If a firm has uses all of its permits, it can try to buy unused permits from other firms. These other firms haven't reached their quota and can continue to pollute or can sell off the right to pollute. Having to purchase extra permits increases the marginal cost of production and so the price to consumers increases as well. In short, this makes production more expensive.

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• The higher price from purchasing more permits creates an incentive. Specifically, this incentive makes companies want to improve production methods to reduce emissions, because they're now paying. This is the internalization of the externality; the companies are now paying for what they use to get for free (the right to pollute). As long as there is a reasonable cap which allows for sufficient production then the market will stay efficient but if the cap is too small it will suppress supply and create a shortage in the market.

• They work 

• TRADEABLE PERMITS are a type of quota scheme, in that the government first decides on a MAXIMUM ALLOWABLE LEVEL OF EMISSIONS, then DISTRIBUTES permits them amongst the firms.

• If a firm goes ABOVE their permitted amount they will be FINED HEAVILY.

• If a firm goes BELOW their permitted amount they can SELL the EXCESS to other firms. 

• This gives firms an INCENTIVE TO SWITCH TO CLEANER FUELS, as they can AVOID THE FINES, and THEY CAN SELL THEIR PERMITS to those firms which are finding it hard to switch.

• EVENTUALLY, any firm that can't keep within its quota will face too high costs, which they will pass on to their customers and will eventually LEAVE THE MARKET, leaving only those firms able to produce within the