In economics, market effectiveness
occurs when the maximum amount of goods and services are produced with a limited
level of resources, provided that no additional output can be produced without
increasing amount of input. An efficient market is Pareto efficient where the
price is equal to the marginal social cost. In some markets, buyer and sellers
have influence in the control of market prices. This is known as market power.
Stability of supply and demand can be affected by market power and cause
inefficiency in the market as it controls the price and quantity. When a
circumstance where the price mechanism leads to inefficient allocation of the
resources and cause a deadweight loss of economic welfare is known as market
failure. There are many causes of market failure; including monopoly power,
negative externalities, imperfect information and public goods. To potentially solve
the problem and increase the state of the economy, the government and public
policy can intervene when market fails. This essay will explore the negative external
effects as a cause of market failure, the welfare losses that occur and
government intervention to address the market failure.

According to Core
Econ textbook, external effects are defined as ‘a positive or negative effect
of a production, consumption, or other economic decision on another person or
people that is not specified as a benefit or liability in a contract’. Therefore,
a negative externality is an external cost suffered by a third party because of
a transaction. Producer and consumer are regarded as the first and second
parties in an economic transaction. The third parties are any individual,
organisation, property owner or resources that are directly affected by actions
of consumer and producers attempting to pursue their own self-interest.
According to Adam Smith as explained in his book “An Inquiry into the Nature
and Causes of Wealth of Nations”, selfishness leads markets to produce whatever
people want, to gain profit, to get rich, you have to sell what public is eager
to buy. (Caplan)The selfishness of producers and consumers cause negative
externality can cause the marginal social cost to exceed the marginal private

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The graph above shows the effect of negative externality.
Without considering externality the quantity is at Q1 which is the Pareto
efficient quantity of goods produced as the marginal social cost and the
marginal social benefit is equal. When there is a negative externality, there
is an external cost because the producers do not take responsibility for the
external cost, the cost is bore by the society. Thus, the supply curve is
effectively shifted to the right because the producers have lower marginal cost.
Now that the supply curve has increased, more goods are produced than the
efficient amount, the good produced with negative externality is Q. Since
marginal social benefit and marginal social cost are not in equilibrium there
is a deadweight loss. The firms producing goods at Q which is more than the
socially efficient quantity Q1 is what causes the market failure.

Negative externalities happen when social cost exceeds the
private cost of goods. Marginal social cost is defined as “the cost of
producing an additional unit of a good taking into account both the cost for
the producer and the cost incurred by others affected by good’s production”. (Project) Thus marginal social
cost is essentially the sum of the marginal private cost and marginal external

 The red area in the
above graph shows the deadweight loss or net welfare loss due to market output
supplied is greater than the social optimum. Net welfare loss exists in two
situations. First, deadweight loss exists when the marginal cost to society is
greater than the marginal benefit of an economic activity to society. Secondly,
if the marginal benefit is greater than marginal social cost (Negative
Externalities, n.d.). In the case of negative externality
refers to the first situation as the market over produce goods that generate
external cost. Any output between Q1 and Q creates a net welfare loss because
of external cost or pollutions emitted.

As explained above, negative externalities occur when third
parties outside the market are affected by production or consumption for which
no compensation is paid. Most common example of negative externality is
pollution. For example, the harmful effect of passive smoking on non-smokers
(third parties) by smokers which may cause health problems and increased
spending on medical bills. Furthermore, the noise pollutions neighbours must
face when music is turned on loudly which causes disturbance to community. These
negative consumption externalities lead to social benefit is less than private
benefits. Externalities also occur when there is no allocation on property
rights over assets and resources, or not predetermined thus uncertain. For example,
the ocean, the air that we breathe are not private property of any individual.
There is no ownership and rights allocated to them, so ships can pollute the
ocean without being afraid of being sued in court, Air pollution from traffic
congestion do not consider the harmful effects to people inhaling the air,
leading to prolonged illness such as lung diseases. (Alvi, 2017).

Negative externalities in goods or services cause the entire
market fails to operate effectively. This is because the cost inflicted to
other people that failed to be considered by individuals who incur the cost and
the way their actions are affecting and impacting others. Government, due to
ownership of industries, has power to prohibit the products and their related
activities that causes negative externalities. However, there are situations
where externalities may not even be corrected because positive and negative
externalities are related to each other. For example, mowing lawn is a n act of
grooming appearance of household is a positive externality, but the noise of
the lawn mower gives a loud nuisance noise to your ears which is a negative

On negative production externalities, governments can impose
large fines and restrict the amount of pollution being dumped. There are
pollution permits by the Emission Trading Scheme(ETS) that can be bought and
sold to put some financial pressure on the firms emitting pollution and causing
negative externalities. Government could also grant property rights as pollutions
in the environment happens because there are no property rights. According to
Ronald Coase in his Coase theorem, allocating property rights will encourage
the appointed owners to protect the resources by allowing them to sue who
exploit the resources (Lack of property rights, n.d.). For instance, the
National River Authority which is now a part of Environment Agency was given
powers to act ‘as if’ it owned the UK’s rivers. This allowed them to police the
rivers and sue the polluters of rivers and illegal poachers.

Negative consumption externalities can be prevented by
government intervention by imposing regulations, levying tax and using
information and nudge theory. Regulation and Laws can be implemented to reduce
negative externality in a market. The Health and Safety at Work covers all
businesses. A ban on smoking in public places was placed by the British
Government in 2007 was in effort to reduce the effect of smoking on passive smokers.
(Health Act 2006, s.28) Local Council can take action towards prohibiting consumption
of alcohol in public and noise disturbance by unruly neighbours because they
are given power by the Parliament to pass bye-laws. Information and nudge
theory can be enforced by the government by putting warning on cigarette’s
packets to discourage people from smoking. Corrective tax can be imposed to
make consumers pay full social cost of the goods. Therefore, consumption can be
reduced and potentially a more socially efficient outcome is created. Overconsumption
can occur if negative externality is not corrected because it ignores external
cost (Tax on Negative Externality , n.d.). Tax should be placed
on goods equivalent to the external marginal cost. This results into consumers
end up paying the full social marginal cost. As shown in the graph below, after
tax is imposed, the quantity of output falls from Q1 to Q2 because the price is
increased with tax price. This situation is considered socially efficient
because Social Marginal Cost(SMC) is equal to Social Marginal Benefit (SMB). (Tax on
Negative Externality , n.d.)

In conclusion, negative externality is a type of market failure
because the marginal social cost is greater that the marginal social benefit. External
cost by negative external effects is bore by the society. The net welfare loss is
due to overproducing and overconsumption of goods which leads to external cost.
The most common example of negative externality is contamination or pollution.
The government can intervene such as introducing tax and imposing strict regulations,
to reduce negative externality and return to market efficiency. 

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