Question

a. Explain and describe the magnitude of the optimal production level of an item that has a negative externality (for example: pollution), if the company takes into account social costs. Compare this level of production with the level of production which only takes into account 'private costs' (private cost).
b. What  policy can be done by the government to reduce the production of goods that have negative externalities and encourage the production of goods that have positive externalities? Explain. 

Answer 1

Ans (a) - If any goods having negative externality, then cost to society is greater than the cost consumer paying. Since consumer is taking decision based on marginal cost equals their marginal profit, and they don't take into account of negative externality.

When a negative externatlity exist in unregulated market, producers don't take responsibility of external cost that exist and they pass the cost to the society. Thus producer have less marginal cost than they would have otherwise and supply curve goes down of the supply curve that society faces. Because the supply curve is increased, more of the product bought than the efficient amount and resulted marginal cost is not equal to marginal benefit and it creates the deadweight welfare loss result.

A common example of negative externality is POLLUTION. For example a steel producing company might release more polluted air into the environment to increase their production. While the company is paying electricity bills, material cost etc and the individual living around the factory pay for the pollution since it will cause them to have higher medical expenses, poor quality of life. Thus the production of Steel has a negative cost to the people surroundings - and this is the cost which companies need not to pay.

Answer (b) --

I. To reduce the production having negative externalities.

1. Government uses taxation system to reduce the production of goods having negative externality. This adds to the producer's Marginal cost and automatically they reduce the production.

2. Government can impose quantity regulations which automatically reduced the production quantity.

II. Government policies to encourage the production of goods have positive externalities --

1. Government provide subsidies.

Advantage of Subsidies --

A. Enables greater social efficiency. Consumer end up paying the socially efficient price which includes the external benefits.

B. If government subsidise public transport, people use more public transport which results to reduce negative externalitites. In the long term, subsidies for a good will help change preferences. Production firms prefers to produce more positive externality goods.

To protect the environment government imposing the green tax to protect the society.