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Pollution Leads To Market Failure Economics Essay

Economic effectiveness for society has been playing an increasingly important role in benefiting human beings. Given the limited resources, producers are being motivated to allocate the resources properly to ensure highest efficiency, which is determined by the equality of price and marginal cost. Then the production and consumption of goods and services can be managed in an efficient way. According to economic theory, the market has been playing a vital role in keeping the balance of production and consumption, the market demand and supply curves lead to the optimum output for the society. However, market failure occurs when economic resources are not allocated effectively caused by the market demand and supply curves working imperfectly. ‘In the absence of any distortions, competitive equilibrium is efficient. By using the term market failure to cover all the circumstances in which market equilibrium is inefficient’ (David, 2005:266).

There are two primary types of market failure. One is called externalities or spillovers, which is caused by producing incorrect amount of goods and services, it may result from a trading process which affects some individuals not directly involved in that process. The other one is called public goods, ‘public goods are generally available to all, such that it is difficult if not impossible to exclude any person, even if they have not paid for the good, from consuming it. Markets often fail to encourage private firms from supplying such good’ (Eleanor, 2005:223). It should be noted here, when it comes to public good, it includes a significant number of consumers sharing the goods or services for free, they are called the free-rider.

In economy, externalities are divided into two parts, positive externalities and negative externalities. The former one is achieved by adding benefit to the third parties or the whole community without compensation. The latter one is incurred by inflicting the cost on the third party without payment to it.

In the real world, pollution is served as an example of market failure. On April 19th 2010, a chemical firm in the southeast of England poured waste into a lake, polluting the lake. The chemical manufacturer favored maximizing profit as opposed to protecting the environment. It resulted in fewer fish production of anglers. ‘Without a “market” for pollution, that firm could pollute the lake without cost. The self-interest leads it to contaminate the lake regardless of the cost inflicts on anglers’ (David, 2005:267). The optimum amount of output is wrongly produced due to the difference between the private supplier’s comparison of benefits and marginal costs and society’s comparison of marginal benefits and costs. Therefore, the optimum output of chemical firm should be reconsidered. To help analyze this case, we use the following diagram.


S: stands for the marginal private cost curve;

S1: stands for the marginal social cost curve;

D: shows the firm’s marginal revenue curve

According to the diagram, in this case pollution, negative externalities occurs. At the output Qe , equilibrium output is achieved by the firm, at which the marginal private cost equals the price of the firm’s output. For the overall community, the social optimum output is at the output Qo, indicating the marginal social cost equals the marginal social benefit of chemicals, the difference between output Qe and Qo leads to the market failure for the chemical firm. In an attempt to achieve highest efficiency, the output level should be reduced from Qe to Qo , at which the marginal social cost equals the marginal social benefit. It’s the optimum social output. In this situation, the resources of chemical firm were overallocated, leading to market failure, as seen in the diagram.

Solutions to market failure have two basic forms, including specific taxes and legislation.

In our case, if the chemical output is very low, there is no need to control the pollution. Whereas higher amount of disposed waste cannot be diluted by the lake, in order to control the amount of pollutant discharged waste by the chemical firm, the government should design policy such as specific tax charges to motivate the firm be aware of the charging fees due to pollution. ‘The task of the environmental economists is to design policy instruments such as taxes and charges, for instance making it economically sensible for households to sort their waste to an optimal extent’ (Frank, 1999:408) .

In our case, as seen in the graph below, a tax equal to T per unit will increase the cost of the chemical firm, which will shift the SS curve to StSt curve. Therefore, the output level will be reduced from Qe to Qo , also it is an equilibrium output for the society as a whole. This means the resources are perfectly allocated.



S: stands for the marginal private cost curve;

St: stands for the marginal social cost curve;

D: shows the firm’s marginal revenue curve

Additionally, the government can also pass legislation to solve market failure. For instance, if the chemical factory will be fined by the government if they dispose wastewater into the lake, they will spontaneously construct more wastewater treatment equipment for discharges. Hence, the firm’s cost increases from S curve to St curve. The output has been brought back to the optimum social output Qo, so the negative externality was eliminated now. In recent years, the importance of treatment capacity can never be underestimated, emissions from the manufacturing industry decreased dramatically, especially in some urban areas where factory are built densely along the river bank. The purpose for charges primarily includes the wish for a fairer allocation of resources. Consequently, the efficient allocation of resources could be achieved and the market failure was eliminated.

Nowadays, a high level of environment pollution contributes to the significant market failure since the use of free common resources, such as air or water. In the long run, of course, the debts of the common resources will be shifted to our whole society. It might be noted that, our government must strike a balance between protecting the environment and developing the economy. We must take responsibility to protect the environment. However, the cost of protection has to be taken into consideration when developing economy. ‘We should use the cost-benefit analysis to determine the optimum extent to which anti-pollution programs should be pursued’ (John, 2007:218) .

In the old-style market excludes the common properties with lower price or no price. In the United States, the market has been extended to a new level for some heavy industries, which allows us to attach a reasonable price tag on each common property. Because of trading of pollution rights in our new market, we don’t need the government intervention any more when we reduce the pollution, the efficiency of the market based incentives for polluters to reduce pollution to an optimal extent can never been underestimated. The manufacturers might be motivated to develop new cost-efficient ways or do research on new technologies to help protect the environment. Hence, negative externalities could be eliminated and the cost of reducing pollution may stay at relatively low level in the long run.

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