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An externality is a cost or benefit of economic activity that is not reflected in market prices

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An externality is a cost or benefit of economic activity that is not reflected in market prices. This means that people don’t consider these costs and benefits when they decide to go ahead with the economic activity or not. This leads to an inefficient allocation of resources if left to the free market, hence externalities are a form of market failure. This topic is important when evaluating government intervention in these markets because some argue that intervention will lead to a more efficient allocation of resources, whereas others believe it will foster economic inefficiency. I argue that government intervention is justified regarding externalities, however too much will lead to more inefficiency. In this essay I will discuss Education as a positive externality, pollution/climate change as a negative externality and how they are relevant to the welfare of citizens. Secondly, I will discuss the three main actions of government; direct provision, regulation, and taxation/subsidy and whether these can be justified based on their advantages and limitations for my examples. Furthermore, I will make use of existing examples of government intervention in these areas and demonstrate the consequences of these externalities, whilst including arguments both for and against intervention, with reference to my research. Finally, I will conclude with my own view based on the central economic principle of an efficient allocation of scarce resources.
Firstly, Education is an example of a positive externality. This is because the benefits of education are not always directly felt by those directly involved, but by the rest of the community and wider society. With regards to Education there are two main types of benefits involved: Economic and non-Economic. An example of an economic benefit is employment. More educated citizens are likely to transfer their productivity and organizational skills to their fellow colleagues through communication and contact. This means that their modes of supervision and management will have a greater impact on production and/or administration, which will foster the growth of a company or organization, benefitting wider society through effective economic management, resulting in higher growth and a healthy functioning of the free market. Therefore, Education is relevant to the welfare of citizens from an economic standpoint. Secondly, a non-economic benefit of education is socialization. Those educated, may transmit values and ideas to wider society that increase social cohesion and solidarity which may decrease crime rates and incur a stable social community.
Economists have argued that government intervention is justifiable in terms of Education based on equity and efficiency. Equity is sharing out resources and income fairly, whereas efficiency is making the most of the scarce resources we have. An example of legislation designed to increase these things is the 1998 Education Reform Act, introduced to give parents more choice. Schools are given government funding based on the number of pupils they admit, and they must publish information such as exam results which can be transferred into exam league tables. This has been argued to increase parental choice and give children access to better schools, justifying intervention. Additionally, this encourages schools to increase their efficiency to attract more students. However, this does lead to equity concerns as parents who can afford to, may move houses to be within a certain catchment area of a good school, whereas working class families, may not be able to do this, which may end up limiting their child’s educational opportunities. This process is known as selection mortgage. In addition, house prices may creep up in these areas making it even more unlikely that children from poorer backgrounds can access better schools. Also, due to the increased focus on examination grades, schools may adopt an unspoken policy of what is known as ‘Educational Triage’ and the A-C economy. This means that pupils may be categorized into one of the following three: Will fail, have potential, will pass anyway. By doing so the pupils who have potential are likely to be focused on as they are the group that could affect the league table position of the school, meaning the quality of education for the other groups may be limited. Hence, government intervention may indirectly affect negatively the quality of education, encouraging some to believe that it is not justified despite its better intentions.
Direct provision of compulsory schooling has certainly improved education, however, there are still problems that arise such as those mentioned. Another action that government can take is regulation and quotas. For example, enforcing that high education institutions take a certain percentage of working class or minority students, in order to increase social mobility and the overall education in society. This opens up opportunities for people, however may decrease competitiveness in education, driving down exam results.
Furthermore, the government could introduce subsidies for working class pupils and students, say for example, a reduction in tuition fees or help with buying resources. This would encourage more people to be involved in higher education and apply to universities such as London universities that may have been inaccessible due to the living costs. However, this may not be equitable for everyone and the government must decide a boundary or point at which financial subsidies are stopped which may cause instability in funds when a government changes. Though, I believe subsidies may be a better way of encouraging education and economic efficiency, as they are less likely to cause adverse effects for the students and parents involved, making some government intervention justifiable.
As mentioned, I believe that pollution/climate change is an example of a negative externality, this is because the activities of these corporations and producers as well as individual consumers lead to environmental damages that are not considered in private prices. Those directly involved don’t bear the cost of their actions, meaning they will be more likely to overconsume or produce. This is relevant to the welfare of citizens because pollution because of human needs and wants directly effects air quality and can in extreme cases lead to breathing problems i.e. asthma and a lower quality of life. This adds strain to the national health services to pick up the cost. Furthermore, it is not just a problem for current citizens. Burning of fossil fuels creates an excess of CO2 which increases the greenhouse gas effect, contributing to climate change, rising sea levels and adverse weather conditions. Without action, this will decrease the welfare of future generations and continue creating problems, hence why governments and economists alike are concerned with the concept of sustainable development. Meaning, economic growth and development meeting our current needs ‘without compromising the ability of future generations to meet their own needs’
As a result, intervention can be justified based on the following grounds. To reduce emissions, investment in cleaner technologies could be beneficial, however this will require financial costs. However, for those involved there isn’t an incentive because they don’t bear the current social cost. Reducing emissions would benefit society, though there are Marginal abatement and damage costs involved. (The cost of the environmental damages and the cost of reducing pollution) Particularly for producers, if the abatement cost is lower than the damage cost then cutting emissions would seem useful and economically beneficial to not only the company but society too. However, this is harder to do in practice because initial investment in cleaner technologies may lead to costs for consumers and society as opposed to the company. There may for example, be an adjustment period, where investment may make the company less profitable, leading to a reduction in wages or unemployment. On the other hand, the rebound effect could take place. Where overall, an increase in efficiency may lead to an overall decrease in prices over time, resulting in a higher consumption, making companies more profitable. Therefore, government intervention could be justified to incur the rebound effect.
Another question arising is where the costs are distributed (equity concerns) A simple principle would be that the ‘polluter pays’ for the damage caused and damage prevention. However, as mentioned previously, this could have negative effects on employment if corporations bear the cost of their pollution. Though, more pressing is the use of domestic fuel, because a larger amount of lower salaries is spent on domestic fuel, which would lead to adverse effects on poorer families. This has previously stopped government taxes rising in the UK. However, if cheaper alternatives are made more readily available to poorer consumers, then it may be justifiable for the government to increase taxes on domestic fuel, to encourage people switching.
One action of government is direct provision. This would involve the government nationalization of polluting industries. By doing so, the government can act in the interests of society by making the social costs equal to the social benefits of production. This could be justified claiming the government could be more efficient in bringing the output level closer to the efficient level. In some ways this seems appropriate as the government is not only representing society, but contains experts needed to monitor the required efficiency levels. In contrast, this is not an appropriate form of action as the government may have competing interests. For example, the government may be more concerned with economic growth and less concerned with the social costs because they must compete in elections. In addition, government terms only last up to five years, so opposition parties may change this provision, creating instability for the industries and consumers, increasing social costs.
Another action of government is regulation, which is common in controlling pollution. Government can, if it is aware of marginal abatement and damage costs, plot the optimal level of say, carbon emissions. From this, it can regulate industries and firms to produce only that amount. This appears to be a simple and effective idea however, it is unlikely the government will be able to precisely regulate output and emissions because of the uncertainty regarding the costs, suggesting this form of intervention may not solve the problem of externalities but make it worse. Another problem is regulatory capture. This means that industries and firms could persuade the government to act in their interests instead of wider society. In this case, the government may set regulations higher above the social optimal or leaving them somewhat relaxed. Regulation can be justified if it is transparent and scrutinized, if not, efficiency may be compromised.
As opposed to limiting emissions, government can impose taxation on said emissions. This would involve adding cost to the levels of emissions, creating s so-called ‘pollution tax’ In theory, this would force those involved to consider their emission rates and perhaps encourage them to invest in cleaner technology to avoid paying higher taxes in the future. This justifies intervention as although not direct, can cause a knock-on effect for industries in the future and makes them aware of the external cost of their activities. In contrast, the same problems arise concerning the schedule costs and regulatory capture. Many firms are able to currently avoid paying taxes by legal loopholes abroad, the same thing could happen in the case of pollution, which would mean that introducing the tax would be a waste of time, which could be spent looking at other, more effective ways of dealing with this particular negative externality.
In conclusion, as externalities are classified as market failures, I believe that government intervention can be justified. In terms of positive externalities, education as my example, it is necessary to increase consumption. This leads to higher economic growth and utility. The most appropriate action the government can take is direct provision to improve access to compulsory schooling and subsidies to increase higher education, the latter increasing accessibility for children from poorer backgrounds, leading to greater opportunities for employment and decreasing the likelihood of these students to require social security benefits in the future. However, too much intervention is not justified because it can widen the gap between the rich and poor e.g. selection mortgage and the A-C economy. Negative externalities such as pollution, also incur justifiability of government intervention. Effective action may include regulation and taxation, though it is difficult for government to ensure the optimal level of output and emissions precisely. On the other hand, the Coase theorem suggests that intervention is unsecure and undesirable due to the self-regulatory nature of the free market mechanism. Conversely, his ideas fail practically as externalities don’t fix themselves. Therefore, appropriate action by government can only be achieved when reliable and valid numbers are drawn up considering abatement and damage costs. Overall, externalities need to be internalized through intervention to ensure the efficient allocation of scarce resources to avoid economic downturn and ignorance of social costs and benefits. However, it is important to review the externality at hand, look at each case subjectively, so that government intervention is not only effective, but socially beneficial.