Economics for managers

ECO 20039

Term 1, 2015
Externalities

In the economical transaction, basically there is involvement of consumer and producer. When
such involvement takes place, there are other people who may be affected by the consequences
and they are called third parties and the consequences of the effects are known as externalities.
There may be both positive as well as negative externalities depending on the nature of effects.
‘An externality is simply a cost or benefit imposed on people by the actions of consumers and
producers’ (Layton, Robinson and Tucker 2012). Planting trees is a good example of positive
externalities, as it brings benefit to the society. Whereas, when the activities of two parties bring
cost to third parties and effect adversely is known as negative externalities. Global warming as a
result of use of fossil fuel can be the negative externalities.

In other word negative externalities are the cost suffered by the third parties and is also called
social cost. These cost are the result of economic transaction between producer and consumer.
As producer produce the product, during the production, there is cost for third party such as air
pollution carbon emission, water pollution, sound pollution and after the production when the
consumer uses the product again there is negative effect for the third parties like wastage of
product, improper disposal of waste. Thus, producer must address these negative effect during
calculation of production cost.

In our daily life, there are various activities which affect other individual that may be directly or
indirectly. Those activities can create either positive or negative effect. So, all the activities that
causes negative effect are called negative externalities. A simple example can be a smoking
person in open area. He may be enjoying the smoke but the person near by may be affected
adversely.

Price S2

P2 E2 S1 External cost of pollution

P1 E1

Q2 Q1

Quantity Demanded

Fig 1: Negative Externality of pollution caused by Brick Factories

In above figure, it shows D as the Demand curve and S1 and S2 denotes the supply curves. E1
stands for the first Equilibrium which is inefficient as it has not taken the external costs to the
society. Furthermore, the industry is making overproduction because of exclusion of external
cost in their price P1. Thus, there in more production than the quantity demanded and is also it is
not socially beneficial. E2 denotes the second equilibrium point which takes the cost of negative
externalities and is socially beneficial. Thus, it is the efficient equilibrium point in the market.
Thus, above figure denotes the external costs as the difference between S1 and S2 (Layton,
Robinson and Tucker 2012).

The impact of negative externalities can't be completely minimized however it can be controlled
to some degree. Such sort of effort can be possible only when there is government intervention.
Government intervention such as formulating and implementing strict rules and regulation,
imposing taxes/charges can be effective method to control the negative externalities and help to
minimize the affect of external costs to society.

Ways to correct the negative externalities

Government can introduce many ways to correct the negative externalities. They can be taxes/
charges & regulation and they are explained below:

i) Taxes/ Charges: Taxes and charges can be used by government to control the negative
externalities produced by the firm. Tax help to correct the inefficient market outcomes. In this
approach, the tax imposed by the government is calculated on the basis of per ton of output
which is equal to the pollution created by them. This help to bring extra cost to the society. This
way of correcting negative externalities is very effective in minimizing pollution because it
enforce the industry to install the pollution control mechanism to reduce the amount of tax. Thus,
in this way market will be in its effective form.

The effective example is levying the taxes by Australian government of AUD 23/tonne carbon
tax for the industries which includes electricity generators, mining and steel producing industries.

Pros and Cons of implementing tax/charges.

Implementing the taxes/charges on the producers by the government, there are various
advantages and disadvantages. This tax imposing can help to reduce pollution as well as
emission of carbon. This reduction protects people and environment ultimately. But, it is not
easy to set the tax rate as well as it is difficult for government to implement the tax.

ii) Regulation: This is another method of controlling negative externalities. In this method,
strict rules and regulation are formulated and implemented for the firms which create negative
externalities. The emission of pollution can be reduced only if government introduce hard and
fast rule because pollution cannot be totally be eliminated but can be reduced to certain level as
elimination cost is much higher than reducing to certain level. But, despite of controlling
negative externalities, regulation is less effective as compared to the tax-based approach. It is
simply due to the fact that tax-based approach third parties are compensated by use of the tax
revenues (Layton, Robinson and Tucker 2012).

Example of regulation implementation is introduction of ban of smoking on the public areas

from July 2007 by British government. This regulation has helped third party to breath in fresh
air in public areas. Likewise, in Nepal, government had restricted the use of Bikram Tempo (a
kind of means of transportation) from Kathmandu Valley to control air pollution and noise
pollution produced by it.

Pros and Cons:

Implementation of regulation has advantages to the firms, as it helps to control pollution to

certain level but if firms could not cope with the new regulation, firm cost will increases and
suffer heavy loss and eventually should close the firm and leave the market.

The negative externalities caused by brick factories in Kathmandu valley in Nepal

Negative externalities are those affect of the economic transaction, which create adverse affect to
the third parties despite of their involvement. Similarly, brick producing factory is one of the
example. As we know that, brick is essential materials for building the houses, temples and
apartments. These brick are produced in large quantities in Nepal. Around, 500 brick factories
are being operated in Kathmandu valley only and the same has increased by 200% since 2000
(Pariyar, Das and Fedrous 2013). Majority of brick factory are using the old traditional way to
produce it and hence pollute the environment. This has mainly affected the local people living
nearby the factory. Mainly, the air quality is affected adversely and as a result people are being
affected due to air pollution (Pariyar, Das and Fedrous 2013). Air pollution has increased three
times in peak season of brick factories (Raut 2003).

Due to increase in number of brick factories there is rapid increase in negative externalities
which is effecting people seriously and environment is also being polluted. It has mainly
increased air pollution and further has created problem in respiratory diseases like asthma
bronchitis, lung cancer, including problems in eyes (Pariyar, Das and Fedrous 2013) including
other problems like cardiovascular system and central nervous system (Joshi & Dudani 2008).
Emission of contaminated air has adversely affect environment including acid rain, fog
formation and loss of biodiversity

Market Structures:

The condition of market where firms or industry can sell their goods and services is called the
market structure. Market structure is also the interaction of buyers and sellers, number of firm’s
interaction in market. There are also barriers to entry and exits of the firm and each firm has the
same capacity to differentiate their product from the competitors (Perloff, 2012). The market
structure can be of four types on the basis of above mention characteristics:

i) Perfect competition:

In this market structure, there are large numbers of independent seller, intense competition
between them, and they sell homogenous product to the buyers. But, in real, this type of market
does not exist. The firms can maximize the profits by minimizing the costs in perfect competition
market structure.

The main characteristics are:

 There is independent large number of small sellers.

 The firms sell homogeneous products to almost same buyers.

 The firm can easily make entry and exit.

 The firm cannot sell the product above the market price as it is price taker.
  There is perfect knowledge of price, quality and availability of goods to each individual
market’s participants

 There is maximization of profit (minimization of losses) at marginal revenue equals

marginal cost (MR=MC).

ii) Monopoly:

In this type of market structure there is single firm which produces the distinctive products as
there are no substitutes of the product and holds 25 percent or more of the market share over the
total market. The buyer has no choice to choose but has to buy product or just leave it and do
nothing with product purchase in the monopoly market (Layton, Robinson and Trucker 2012). In
the monopoly market, there is single product and hence has control on the prices so the firm is
the price taker. Profit can be maximized by deciding by the combination of price and output.
There is more profit for the firm when marginal revenue equals marginal cost (i.e. MR=MC)

The main characteristics are:

 A single firm has full access over the market and all the key resources.

 The main feature is production of unique products with no close substitutes to that
product.

 The firm is a price taker and decides its own combination of level of price and output.
Due to various barriers such as legal barriers, technology, economies of scale and
ownership of key resources, there is no access of other firm in the market.

 There can be earning of supernormal profit in both short run and long run because the
demand curve of this market is downward slopping.

 There exists price discrimination as it sets its own price and has dominant on market.

iii) Monopolistic Competition

In this market structure there are many small sellers, differentiated products and easy entry and
exits of the firms. In this structure, the existing small firms have market power and earn positive
profit. But, when new firm enter they cannot compete in the market and cannot earn positive
profits (Perloff 2012). Despite of being similar to perfect competition, there is large number of
small firms competing and the firms in this market are price taker thus holds some control over
the price.

The main characteristics are:

 This structure have many small sellers, holds small portion.

 There is no barrier to entry and exit out of the market for the firm.

 Price is set upon the basis of production output level, market, quality and cost of
production.

 The demand curve is downward slopping as in the monopoly because they sell
differentiated products.

 In this structure, the firm have limited control over price as they are price taker.

iv) Oligopoly

In this market structure there are few large firms and they hold the large share of the total market
and have dominance over the market. In this structure of market, major large firms dominate
total market share but there can be small firms operating as well. The firms under oligopoly
market compete among each other by using their specific brand names and advertising. When a
firm makes changes to the prices or the product design, other rival firms would be affected
(Sloman and Sutcliff 1998). Thus, the firms are interdependent to each other as there are few
large sellers, either homogeneous or differentiated product and have barrier to entry (Layton,
Robinson and Tucker 2012).

The main characteristics are:

 There is interdependence between the few dominating firms in the market

 The existing firms create barriers to the new firm to enter in the market as there is various
factor which create barriers like economies of scale, control of key resources, technology,
legal barriers and goodwill and patents rights held by existing firms.
  In this structure, products can be homogeneous or differentiated.

 There is interdependence between the firm for making decisions about the price and the
products.

 As few firms dominates the total market so the firms are the price makers.

In this case study, brick factories of Kathmandu valley of Nepal, falls under Oligopoly market as
there are numbers of firms operating but only few major firms can dominate the market share.
The firms produce a mostly homogeneous product (with different names and brands) i.e. bricks.
As feature of oligopoly, price and output are decided by the interdependence of the firms that are
in market. Due to lack of resources, legal barrier and economics of scale, there is difficult to
enter in the market for new firms.

Effects of negative externalities on market outcomes and Dead weight loss

Negative externalities are the excess cost to the society which occurs due to the over production
by the firms. In this case study, the emission of pollution by the brick factories of Kathmandu
valley has adversely affect the health condition of people and also affect the environment. Also
negative externalities have made the firm inefficient as they are producing more than optimal
quantity and they may face market failure because of increase in cost of production. With the
present of negative externalities, market and society both are not benefited. Due to negative
impact of brick factory in the mind of people, they will protest the existence of factory. If the
factory cannot address the pollution control mechanism, they cannot exist in the market. Those
factory cannot compete which are weak financially and will be shut down. There is less supply
and will not match demand. As a result, optimal output is not produced in the market.

Dead weight loss

From the name it is clear that it is loss due to inefficiency of equilibrium between supply and
demand. It is also the loss of economic effectiveness when there is lack of equilibrium of a good
or service. It is the effect of the monopoly prices, externalities, taxes and subsidies. It occurs
when there is production of more output, whose cost of production is more to the benefits to the
society. In other words, it is excess burden of the market. As a result, the market is not efficient
and the market outcome is not achieved.
Price S= SMC

S=PMC

P2 Dead weight loss

P1

D= PMB

Q2 Q1 Quantity Produced(Q)

Fig: Dead Weight Loss due to negative externality

The above figure shows, x-axis and y-axis represents as quantity produced (Q) and the price (P)
charged per the brick produced respectively by the brick factories in Kathmandu valley. There is
private marginal benefit (PMB) as demand curve and private marginal cost (PMC) and social
marginal cost (SMC) as supply curve in the above figure. When the brick factory produces the
brick where PMC equals PMB, the output quantity will be equal to Q1 and the price of the brick
will be P1. But, in this situation of production, the industry ignores external costs. Also, there is
inefficiency in market as SMC is greater than PMC (SMC>PMC). But when the industry
produce Q2 quantity the market will be efficient at the output Q2 and Price P2 where SMC
equals PMB and this level of quantity and price is also socially beneficial. But, the firms produce
at Q1 to make higher profit and as a result ignore the extra cost to the society due to their
overproduction. Thus, Dead weight loss occurs which indicates that the SMC is greater than
PMC ([Link]).

In this case study, when Nepal government has imposed tax on the brick production factory, the
firms have to raises the prices. As tax increases firm raises their product price so that they can
recover the tax paid to the government and finally as a result of increase in the brick price, the
consumer have to pay higher prices. Due to this action of government, the market cannot be
efficient and market outcomes are not achieved. Furthermore due to increase in brick factories,
there is increase in pollution which ultimately affect the people, society and environment as a
whole. Thus, in this instant, these brick factories which pollutes the environment cannot be
eliminated but can be controlled by the government by taking better steps and control those
negative externalities in preventive way.

Actions/remedies taken by Nepal Government to addressed negative externalities brought

by Brick Factories of Kathmandu Valley

 Registration of the industry in VAT office

 Closing outdated technology like Bull trench kiln technology (Raut 2003). Since 2004,
government is encouraging brick industry to use fixed cleaner chimney and vertical shaft
brick kilns (VSBK) (Joshi & Dudani 2008).

 Introduction of separate industrial area far from the residential areas.

 Regulation for the standard for the height of chimney including the amount of pollution
they can emit. The industry that have installed fixed chimney can emit 700 Mg/Nm2 at
maximum and those which have installed VSBK can emit 400 Mg/Nm2 at its maximum.

Alternative options for dealing with negative externalities for Brick factories.

 Public awareness is one of the most effective measure to avoid and minimize air pollution
and to be safe from its negative effects.

 Imposing taxes to the brick industries for emitting smoke.

 Using the environment friendly technologies for producing the bricks

 Formulation of strict regulations, laws and penalty for controlling control the pollution
and encouraging emissions trading of carbon.

 Emission trading can help the government to set limit to emit the pollution.

 Encouraging the use and installation of environment-friendly brick kilns to reduce

amount of pollutants.
References:

Joshi, S.K and Dudani, I 2008, “Environmental health effects of brick kilns in Kathmandu
valley”, Kathmandu University Medical Journal, Vol. 6, Issue 21, pp. 3-11.

Layton, A, Robinson, T and Tucker, IB 2012, “Economics for Today”, Cengage Learning,
Australia.

Perloff, JM 2012, “Microeconomics”, Pearson Education Limited, England.

Pariyar, S. K, Das, T and Ferdous, T 2013, “Environmental and health impact for brick kilns in
Kathmandu valley”, International Journal of Scientific and Technology Research, Vol 2, Issue 5.

Raut, A.K 2003, “Brick kilns in Kathmandu valley: Current status, environmental impacts and
future options”, Himalayan Journal of Science, Vol 1, Issue 1, pp. 59-61.

Sloman, J. And Sutcliffe, M. 1998, “Economic for Business”. Pearson Education Limited,
England

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