When it comes to a firm deciding what output to produce,
they generally take into account only two things: How much they can sell the
good for and how much it costs to produce. Using this information, they set out
to maximise profit by producing where the marginal costs are equal to the marginal
revenue. This means there is a strong incentive for the firm to keep costs as
low as possible to maximise profits.
Many environmental goods do not come with a price tag, they
are treated as being free by the firm. This 0 price tag means that firms put no
effort into using these resources efficiently. The costs that the firm should
incur when using these goods are known as the external costs. They do not get
taken into account by the firm when making production decisions and therefore
we experience over production. External costs are the difference between the
social cost of an economic decision and the private costs (costs to the one
making the decision).
Here we can clearly see that at the price P the optimal
production would be Q*, if the social costs were taken into account. But
production is actually at Q because only the firms private costs are looked at
when deciding how much to produce. This is an obvious overproduction and it is
due to environmental goods not having a price and therefore being treated as
free.
Another way to map this out is using marginal external
costs versus the marginal net private benefits of production. The marginal net
private benefit is the additional benefit the producing firm gains from each
additional unit of production. The marginal external cost is the cost to the third
party of each additional unit of production. Each additional unit of production
adds an increasing amount to the costs but a decreasing amount to the benefits,
hence the shape of the curves you're about to see.
In the scenario here, the firm produces at the point Q.
Why? Well, they do not care about the marginal external cost of their actions
so we can ignore that curve for now. At point Q, benefit for the firm is
maximised. Any more production past point Q and benefit to the firm will start
to decline. Any point before Q will mean there is more potential benefit to
gain. The socially optimal point of output/pollution would be at Q*. This is
where the profit from producing the last unit of pollution equals the cost of
producing it. Essentially, here, benefits = costs. The external cost has been
paid for and the true value of the environmental good has been taken into
account. The problem is getting firms to produce at this point. There needs to
be a form of incentive to encourage firms to reduce production and therefore
pollution to the socially optimal point. How to do this?
That's market failure in an environmental sense. Thank you
for reading, comment if you have questions.. blah blah blah. Have a good day.
Sam.
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