<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. 

• "...if you tax the process, companies will invent a cleaner one."

• An INDIRECT TAX ON CARBON is applied to EACH UNIT OF CARBON PRODUCED; as such, it will add to the overall costs of production.

• 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 and LESS OF A THREAT TO EMPLOYMENT.

• 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 (Which is based on the process and not the output) should fall. As such there is a new MSC curve based on the smaller external cost.

        • • • For example, before the tax, the external cost per unit was large due to the fuel used giving off 3kg of CO2 per kg burned, but after they switch fuel it only gives off 1.5kg of CO2 per kg.

      • Secondly, as most firms won't be able to reduce their emissions 100% 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.

• BOTH TAX TYPES:

  • • • • 👍 They make it the responsibility of the producer to cover the costs (‘Internalise the cost’).

        • 👍 Reduces the overproduction.

        • 👍 A fixed amount allows firms to budget and plan.

• CARBON TAXES ONLY

  • • • • 👍 Taxes on emissions and tradeable permits CREATE INCENTIVES to switch to less polluting production methods.

        • 👍 Firms that can change at low-cost, do so to quickly to avoid the tax.

• BOTH TAX TYPES:

  • • • • (👎) Working out exact tax to match the external cost is virtually impossible.

        • (👎) There must be a method to check and monitor the emissions, which will be costly.

        • (👎) There is no specific absolute limit on pollution levels, as some firms could afford to continue polluting, so the outcome is uncertain.

• "Here are your limited 'carbon permits'; go trade!"

• 'CAP' and 'TRADE 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 is gets steadily reduced, usually annually, allowing firms time to adjust) then DISTRIBUTES pollution permits/allowances (for example one permit per tonne of emissions) amongst the firms, BASED ON THEIR POLLUTION LEVELS.

• 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

INSERT DIAGRAM SHOWING SUPPLY AND DEMAND WITH THE SUPPLY CURVE SHIFTING LEFTWARDS AND THE PRICE RISING AND OR DEMAND INCREASING 

SAME AS CARBON TAXES:

• • • • • 👍 They make it the responsibility of the producer to cover the costs (‘Internalise the cost’).

        • 👍 Tradeable permits CREATE INCENTIVES to switch to less polluting production methods, NOT only will they avoid the tax BUT they can get a reward by selling their spare ones to firms that find it hardest to chaneg so quickly if at all.

SPECIFIC TO CAP AND TRADE:

• • • • • 👍 The overall pollution level is 'capped with certainty.

• SPECIFIC TO CARBON TAXES:

  • • • • (👎) Working out exact 'Cap' to match the external cost is virtually impossible.

        • (👎) Similar to carbon taxes, there must be a method to check and monitor the emissions, which will be costly.

        • (👎) Due to 'carbon leakage' the demand may not be strong enough to raios the price sufficiently for teh firm sto be incentivised to change.

        • (👎) As the price of the permit is openly traded and supply is gradually reduced, the actual price can be very volatile, making it difficult for firms to manage budgets.

• 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?

• 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. 

• 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.

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