Externalities are Market Failure or Failure of Markets
It can be considered that the economists believe markets are unambiguously resulting in efficient results. It is with the total surplus maximized when the markets operate without interference from the other institutions. If it were the case, then there would be no efficient role for the non-market institutions in society along with their justification having concerns about the distribution of surplus. It specifically concerns about the equity and fairness because these relate to the allocation of market of scarce resources (Menanteau, Finon and Lamy 2003, Sutherland 1991). However, such issues play specific role in the justification of non-market institutions that are being motivated by efficiency rather than equity concerns. These conditions are known as externalities and they emerge with the decisions of certain parties in the market having a direct impact on others in a way that is not captured by market prices (Brown 2001, Owen 2006, Mulder and Hagens 2008). This paper is considering the energy economics while reflecting the negative externalities.
Externalities having Negative Costs to Society
The negative externality causes the quantity of equilibrium to be larger than the socially optimum quantity. The social cost curve is identical to the cost of organization in the absence of the externality. However, the negative externality causes the social cost curve to include the private cost for the production of the products along with the additional cost paid by people. In order to correct the inefficiency due to externalities, the quantity produced would be changed to the optimal level of the additional cost of the externality (Allcott and Greenstone 2012, Longo, Markandya and Petrucci 2008). A new equilibrium having the social cost curve fulfilling the demand curve indicating the socially optimal level. It can be said that the socially optimal level of production is lower than the privately optimal level because the private market is not paying the full cost of the actions. Minimizing the quantity produced in the private market increasing the total social welfare (Duke and Kammen 1999, Scheraga 1994, Allcott and Greenstone 2012, Menanteau, Finon and Lamy 2003).
A negative externality exists when the production and consumption of products results in costs imposed on people not involved with the transaction or the use of the good. For instance, an individual smoking a cigarette in a restaurant has made a decision to smoke depending on the marginal benefits and marginal costs. It is found that the individuals living near industry emitting pollution apart from the fact that the people who do not produce or consume that specific produced good pay the cost of pollution (Pitt 1985, Jansen and Seebregts 2010, Dincer 2000, Jaffe, Newell and Stavins 2004). In order to understand the negative externalities, it can be said that the introduction of the concept of the social curve.
The main reason of the negative externality of being inefficient is due to the market equilibrium reflects the private costs of production. If the people involved in the transaction of the goods that could be forced to pay the social cost along with the private cost of producing the good that can solve the issue and the efficient market equilibrium can be reached. It is known that the producers and consumers are forced to internalize the externality when the producers and consumers of the goods (Allcott and Greenstone 2012, Jansen and Seebregts 2010, Longo, Markandya and Petrucci 2008, Mulder and Hagens 2008).
Externalities of Energy
The externalities of energy refer to the social impacts arising from the process of production of energy that are not being reflected in the market price of the energy. One of the major example is the pollution as it is observed in Japan that combustion of gases from the fossil fuel power stations are released into the atmosphere. It influences the natural environment but the health of local residents and the private property of third parties not associated with the energy production activities (Dincer 2000, Menanteau, Finon and Lamy 2003, Mulder and Hagens 2008, Sutherland 1991, Allcott and Greenstone 2012, Longo, Markandya and Petrucci 2008). It is an example of externalities of energy and the cases like this with negative impacts are referred to the external cost. The costs incurred for installing such removal equipments that were incorporated into the production price of energy. It implies that the negative affects of combustion gases that were reflected in the market price.
Moreover, the costs of production that are faced by each of the producers of energy require the imposition of costs of pollution in society (Allcott and Greenstone 2012, Duke and Kammen 1999, Brown 2001, Jansen and Seebregts 2010, Mulder and Hagens 2008, Owen 2006, Longo, Markandya and Petrucci 2008). The following figure provides the market demand and supply graph for the production of hero cards. There are production externalities due to which the market can produce xM at the price pM with all the consumers and producers doing best in equilibrium. The consumers can get the shaded blue area in surplus while producers get the shaded magenta area. It can be said that the production of hero cards produce pollution but every card produced is imposing a pollution cost on society. Neither a cost that is borne by the people consuming nor those produce that produce it (Pitt 1985, Menanteau, Finon and Lamy 2003, Brown 2001, Allcott and Greenstone 2012, Jaffe, Newell and Stavins 2004, Longo, Markandya and Petrucci 2008, Menanteau, Finon and Lamy 2003).
Figure 1: (DeCanio and Watkins 1998, Hassett and Metcalf 1993, Jaffe, Newell and Stavins 2004)
The part b of the above graph is reflecting the green curve labeled as SMC. This curve represents the social marginal cost of producing hero cards. It includes the marginal costs of producers that are captured in the market supply curve but it includes the additional cost of pollution that is imposed on others. It can be said that the social marginal cost curve is required to lie above the supply curve because it includes costs in addition to the ones incurred by producers (Allcott and Greenstone 2012, Duke and Kammen 1999, Jansen and Seebregts 2010, Longo, Markandya and Petrucci 2008, Pitt 1985, Menanteau, Finon and Lamy 2003). The reason behind it is that the SMC curve is parallel to the supply curve, which implies a constant marginal cost of pollution for the produced hero card.
Consequently, Barney would decide the continuation of producing the long-term benefits from the production as represented by the marginal willingness to pay of the overall cost of additional production for society. The Barney would certainly produce the hero card due to certain consumer to whom this card is worth more than the costs incurred by society as measured by SMC (Hassett and Metcalf 1993, Duke and Kammen 1999, Allcott and Greenstone 2012, Jaffe, Newell and Stavins 2004, Longo, Markandya and Petrucci 2008, Longo, Markandya and Petrucci 2008).
It can be said that the competitive markets can produce sufficiently in the presence of negative pollution externalities. Consequently, the potential for government policy for enhancing the efficiency exists while reducing the deadweight loss from the overproduction of market. It is known that the taxation of goods is one policy tool that can minimize the output of market. In the absence of externalities, it is not efficient because the market allocation of resources is required to be efficient. However, this minimization of inefficient output level to minimize rather than increase in the deadweight loss (Dincer 2000, Hassett and Metcalf 1993, Jansen and Seebregts 2010, Longo, Markandya and Petrucci 2008, Menanteau, Finon and Lamy 2003, Mulder and Hagens 2008, DeCanio and Watkins 1998).
For instance, it can be said that the market demand and supply curves along with the optimal production level xB that can be selected by Barney. It is depicted in the panel of the graph. It is apparent that the buyers in the market are most probably to face the higher price pB while sellers are to receive the lower price pS with the difference between the two prices that represent the payment t per unit in taxes (DeCanio and Watkins 1998, Hassett and Metcalf 1993, Longo, Markandya and Petrucci 2008, Menanteau, Finon and Lamy 2003, Owen 2006, Jansen and Seebregts 2010). In the panel b, the more directly the efficiency of tax is apparent. In the absence of the tax, the market produces the output xM and at the price p M (Jaffe, Newell and Stavins 2004).
Figure 2: (Jansen and Seebregts 2010, DeCanio and Watkins 1998, Duke and Kammen 1999, Menanteau, Finon and Lamy 2003)
In the presence of the externalities, the price signal is distorted as it does not coordinate production and consumption. The tax removes the distortion while causing the market to internalize the externality. For the government to be able to impose an efficient Pigouvian tax t, the optimal quantity is required to be…