Negative Externalities of Production By Sean Coupe

Free Market for Dairy Products SMC

Why the Market Fails :  This occurs when the free market delivers an inequitable or inefficient allocation of resources, creating deadweight loss (DWL).  This happens in a market with negative externalities of production. E.g : Dairy Farming, as it creates pollution through stock effluent run off into rivers which is socially undesirable.  Producers produce above the socially desirable level in the free market, creating DWL.  DWL is created because not all of the spill-over costs of dairy farming are covered by the consumer or the producer surpluses, instead a third party incurs this cost.  Failing free market with DWL is shown on the previous graph.

Market for Dairy Goods w/ Tax SMC Ptax Qtax Ppr

Possible Policy 1 :  One method government could apply to correct the failing market would be the introduction of a sales tax on dairy products.  Sales tax causes a rise in price therefore a decrease in quantity consumed. The sales tax, implemented effectively could raise P so that Q decreases to the socially desirable quantity.  PMC Curve would move to SMC (PMC + Tax).  This would eliminate DWL, internalising the negative externalities of production within the market, therefore increasing efficiency.  However this is inequitable, as P rise for dairy products means it becomes relatively more expensive for low income groups to purchase dairy goods relative to high income groups.  Also farmers that do not pollute suffer the decreased profits cause by those farmers that do pollute.  However tax revenue could be used to offset negative externalities of production, and research into decreasing environmental impact of farming.

Market for Dairy Goods w/ Regulation SMC Preg Qreg

Possible Policy 2 :  Another possible policy could be the introduction of regulation in the market; law could state that farmers who pollute a lot are fined.  Fines would cause costs of production to rise, thus increasing price as the PMC decreases to the SMC (PMC + Regulation).  This decreases output to the socially desirable level, and internalises the negative externalities of production thus eliminating DWL, raising market efficiency.  It is vertically inequitable as P rise for dairy products means it becomes relatively more expensive for low income groups to purchase dairy goods relative to high income groups.  Horizontally equitable as only farmers who pollute must pay fines.

Policy Recommendation :  Sales tax is recommended over the policy of regulation.  As both policies have inequitable aspects, and increase efficiency by eliminating DWL and internalise externalities, it’s the arising benefits of sales tax make this is the preferred option.  A sales tax creates revenue for the Government that can be used to offset the effects of pollution, or used to fund research into how to reduce pollution.  Recommended over regulation as the potentially small revenue gained from fines can only be used to offset the costs of the beaurocracy of handing out fines and ensuring they are paid.  Tax reduces the price producers receive as well as output, providing further incentive to farmers to eliminate pollution and possibly have the tax lifted in the future.  Therefore a sales tax will be more effective in achieving the overall goal of eliminating pollution due to dairy farming and meeting the demands of society.