Showing posts with label externalities. Show all posts
Showing posts with label externalities. Show all posts

Operating Controls | Forms of Operating Controls | Cost and Benefits of Operating Controls

Operating controls are government’s regulations or standards that limit undesirable behavior by compelling certain actions while prohibiting others. Regulation through operating control, that is, control through government directive is an important and growing form of regulation. These regulations are designed to limit or control socially undesirable activities of firms. This tool of regulation is one of the most popular methods of correcting market failure due to negative externalities. Through these means, the government will protect and advance that public interest in health, safety and security, the quality of the environment, and the social and economic well-being of people.

Government sets the rule of game for the operation of private sector business activities. The legal framework sets the legal status of business enterprises, ensures the rights of private ownership, and allows the making and enforcement / implementation of contracts. Government also establishes the legal “rules of the game” governing / administering the relationships of businesses, resource suppliers, and consumers with one another. Units of government can judge economic relationships, try to find foul / dishonest play, and exercise authority in imposing appropriate penalties.

Forms of Operating Control


Operating controls may be in various forms:

i) Control over environmental pollution

Environmental pollution is a negative externality created by private business firms involved in production activities. Government uses its different tools to correct the negative externality. For example, government sets limit for automobile emissions, fuel efficiency and safety standards to control environmental pollution. The government of Nepal, for example, has introduced Nepal Vehicle Mass Emission Standards 1999 (2056 B.S.) to control pollution created by vehicles. The role of the Environmental Protection Agency (EPA) of the US Federal Government is to control pollution.

ii) Control on food products

Firms involved in the production and sales of food products, drugs and other substances could harm consumers by producing and/or supplying low-quality or substandard items. So, it is essential to regulate such production activities. Government regulates such activities through food and drug acts. The act designed by the government to control the quality of Food forces the private business to maintain the standard mentioned in the act.

For example, The Pure Food and Drug Act of 1906 in the US sets rules of conduct governing producers in their relationships with consumers. It prohibits the sale of adulterated and misbranded foods and drugs, requires net weights and ingredients of products to be specified on their containers, establishes quality standards which must be stated on labels of packaged foods and prohibits deceiving claims on patent-medicine labels. These measures are designed to prevent false activities by producers and to increase the public’s confidence in the integrity of the market system.

iii) Industrial work conditions

Government controls the working environment of a factory by using labor laws and health regulation including the provisions relating noise levels, toxious gases and chemicals, and safety standards. For example, The Occupational Safety and Health Administration (OSHA) agency of the US Federal government requires that employers inform workers about risks and mandates firms to reduce risks.

iv) Wage and price control

Government also regulates wage through minimum wage law and price is also regulate to control inflation. Wage and price control policy of the government limits the freedom of the firm to determine wage and price.

v) Control in the operation of financial institutions

Government attempts to control the loan advancing activities of commercial banks by setting the minimum required reserved ratio (RRR) under which every commercial bank is required to keep certain percent of the deposit in cash. Banks cannot advance loan by undermining that RRR.

vi) Control in transportation

Government also regulates the operation of airplanes and vehicles. For example, the government fixes the limit of the weight of luggage / baggage in airplanes, (normally up to 15 kg, it is free and beyond that passengers have to pay additional charges), prohibition on carrying passengers on the top part of passenger buses, the Federal Aviation Administration (FAA) of the US sets standards for airline safety whereas The National Highway and Traffic Safety Administration (NHTSA) monitors risks and sets standards for automobiles and highways.

Cost and Benefits of Operating Controls


The question of who pays for such regulation is seldom answered by simply referring to the point of tax collection or point of the incidence of tax burden. This economic cost of regulation is often transferred to consumers or suppliers, as determined by the relative price elasticities of the demand and supply functions.

We can discuss the benefits of much operating controls in terms of information and risk. We know that there are externalities associated with information and risk. If every person who flew on an airplane had to have it checked for safety, the costs would be huge. It is much cheaper to have an agency like the Federal Aviation Administration (FAA) checks for airline safety. When the FAA sees a way to make a change in safety requirements that will reduce risk and thereby save lives, it has the authority to require that the airlines make these changes. Similarly, it would be costly for each consumer to check the accuracy of all advertising claims, or to test the efficacy of a new drug. By giving the Food and Drug Administration (FDA) of the US Federal government, the responsibility for testing new drugs, the public saves considerably on time and effort.

To be sure, without the government, private organizations would probably keep going to provide testing and information about products. Consumers Union is one such organization and many industries in the US economy have private watchdog organizations. But because of information externalities, the private actions would probably fall short of the efficient level.

The benefits from providing information about risks must be considered in light of the costs. The FDA might hold back a new drug for testing to reduce risks but this is costly to the people whose lives could be saved if the drug were approved. The building code requirements for a construction site might raise the cost of construction significantly. Frequently, these costs are not visible. No one knows that an illness might have been prevented with a new drug, but everyone knows when a faulty new drug causes severe illness or death.

The actions of the FDA, Occupational Safety and Health Administration (OSHA), and other agencies of the US Federal government involved in social regulation are frequently criticized because of the costs they impose on firms and consumers. Very angry letters and critical editorials about the costs are common. It is very difficult to estimate the costs, but some economists have tried. It has been reported that the cost estimate of implementing the operating control measures in the US economy ranges from around 3 to 5 percent of GDP per year for all programs. On the other side, the programs are popular, and they clearly do reduce risks and provide information.

Ultimately, the degree of government intervention will be decided in the give and take of the political process. But careful cost-benefit analysis on a program-by-program basis, as urged by many economists, would help in the decision-making process.

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Externalities in the Economy | Economic effects that occur from the production or the use of goods

Externalities are pervasive and significant phenomena in modern societies. The term externalities refer to the economic effects which occur from the production or the use of goods to other parties or economic units. It is said that public goods and externalities are not un-related. In other words, public goods and externalities are related. Externalities may affect a large number of people in a uniform manner, in which case the externality is essentially a public good (or public “bad”).

For example, education increases the skills and general welfare of the person being educated and may in addition, make the person better citizen. That is, the person’s behavior in political process may be more wise and informed, and an informed may make better political decisions. Since, such decisions affect every one, the education of each person produces an external benefit that accrues to the members of the community and the nation in which person reside.

This external benefit is a public good that is jointly produced along with the private goods (marketable skills) resulting from education.

Similarly, air pollution generated by an iron mill’s smoke and the exhaust of automobiles are public bads that are produced jointly with private goods (iron mills and private transportation). Again, the railways using a lot of coal in firing steam locomotives put the residential and other areas near the railway loco sheds to a lot of suffering on account of the smoke nuisance. These are the cost to the society but not to the individual undertaking.

In the above examples, public goods, i.e., benefits and public bads that are produced with private goods are known as externalities. These are the cost to the society but not the individual undertaking. This causes divergence between private cost (internal cost) and social marginal cost or external cost of benefit, of the goods in question. Market takes into account of internal costs and not the social marginal cost or external cost (or benefit) of the goods in question. Consumers reveal their preferences for the benefits which are wholly internalized (rival) but not for the external benefits, i.e., purification of air (non-rival). Thus, market fails to achieve efficient allocation of resources when externalities are present.

To be more clear, let the production of a commodity, say iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, have two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron; and (ii) the costs borne by the members of the community in the form of air pollution damages. Market takes into account first component of the above costs but not the second. This is the cause of divergence between private cost (internal cost) and the social marginal cost (external bads). Hence, markets fail to achieve efficient allocation of resources when externalities, i.e., external costs or benefits are present.

Thus, externalities can take many forms. For example, external benefits from education: children gain from having educated parents; society benefits in so far as education reduces crime, social un-rest, unemployment and welfare costs; society benefits from an educational system that inculcates acceptable social values, improves communication and strengthen democratic institutions, on the (external bads) side are many forms of pollution and other disseminates such as congestion and noise etc.

i) Externalities in the form of external benefits

Problems of social goods-type arise not only in the budgetary context but also wherever private consumption or production activities generate external benefits. Suppose, for instance, that A derives benefits being inoculated against polio but this also benefits others, since the number of potential carriers and hence the danger of infection, is reduced. Similarly, by getting educated, A not only derives personal benefits but also makes it possible for others to enjoy association with a more educated community. Since, large number of other consumers may be affected, market does not work and a budgetary process is needed to secure preference revelation. But budgetary intervention in this case will not involve full budgetary provision rather, it will take the form of subsidy to private purchases.

ii) Externalities in the form of external costs or bads

Let us now consider a case of a commodity which generates external costs or bads. Suppose, the production of iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, has two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron, and (ii) the costs borne by member of community in the form of air pollution damages. However, the second component of cost is not taken into account by the market. In fact, private activities, whether in production or consumption frequently give rise to external costs which are not accounted for by the market. Hence, public (Government) intervention is needed to get this part of the cost to be internalized.

iii) Efficiency and equity problems

In the first place, failure to account for external costs leads to an over supply of production question (i.e., here iron) and an under supply of the benefits (i.e., clean air) which are reduced by pollution. This is the efficiency problem. If the damage cost of pollution were internalized, resource use would become more efficient. The price of iron would be higher, less iron would be produced and the air quality would be improved.

Second, the existence of pollution poses distributional or equity problems. Through, the loss of environmental quality, consumers of air are forced to subsidize consumers of iron, much as they would if a tax were imposed on them (consumers of air) and transferred to the latter (i.e., consumers of iron). Moreover, the incidence of pollution damage may fall with different weight upon low income and high income families, and this affects the distribution of real income. The same goes for the cost of pollution prevention and the net gains to be derived there from.

iv) Efficient solution

It should, however, be noted that air is a public property, it is a social good. The principle of exclusion does not apply. Hence, market fail to take into account external costs or the damages caused by air pollution. The benefits of this good are shared by all those who are damaged by pollution.

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Methods of Regulating Environmental Pollution | Direct Regulation and Effluent Fees for Optimal Pollution Control

Why is regulation of environmental pollution felt necessary in recent days? How do you determine the optimal level of pollution control from social point of view? What are the various methods applied by the government to minimize the problem of pollution?

Environmental pollution has become one of the major political and economic problems in the present era. Environmental pollution results from the negative externalities. Externalities may be eliminated by the clear definition of property rights if the parties involved are not very numerous. Otherwise, transaction costs are too high and externalities persist. This is precisely the environment pollution, which refers to air pollution, water pollution, thermal pollution, pollution resulting from garbage disposal and so on.

As pollution results mostly from automobile exhaust and smoke from factory and electricity generating plants through the combustion of fossil fuels, which released particles into the air. While it is difficult to measure precisely the harmful effects of sulfur dioxide, carbon monoxide, and other air pollutants, they are known to cause damage to health and to property. Water pollution results from dumping raw sewage, chemical waste products from factories and mines, and runoff of pesticides and fertilizers from farms into streams, lakes, and seashores. This reduces the supply of clean water for household uses and recreational uses.

Thermal pollution results from the cooling off of electrical power plants and other machinery. This increases water temperature and kills fish. The disposal of garbage such as beer cans, newspaper, cigarette butts, and so on, spoils natural scenery, as do billboards and posters. To this, visual pollution must be added noise pollution and many other forms of pollution.

Environmental pollution results whenever the environment is used as a convenient and cheap dumping ground for all types of waste products. It is convenient and cheap from the private point of view to use the environment in this manner because no one owns property rights to it. As a result, air and water users pay less than the full social cost of using these natural resources, and by so doing, they impose serious external costs on society. Since property rights are ambiguous and the parties involved are numerous (often running into the millions), it is impossible and impractical (too costly) to identify and negotiate with individual agents. The external costs of environment pollution cannot be internalized by the assignment of clear property rights and so government intervention is required. This intervention can take the form of regulation or taxation. However, appropriate corrective action on the part of the government requires knowledge of the exact cost of pollution.


i) Optimal pollution control

The optimal level of pollution is that level at which the marginal social cost of pollution equals the marginal social benefit (in the form of avoiding alternative and more expensive methods of waste disposal). Zero pollution is an ideal situation, but as long as pollution is the inevitable by-product of the production and consumption of commodities that we want. Economists advocate optimal pollution control instead that is, we should be prepared to accept (as inevitable) that amount of pollution which, at the margin, balances the social costs and benefits of pollution. The marginal loss (cost) increases with rising amounts of pollution. When the firm does not incur any cost for discharging waste, it will do so until the marginal benefit becomes zero. That is, as long as the firm saves some cost by discharging its waste. However, pollution does impose a cost on society as a whole. 

ii) Direct regulation and effluent fees for optimal pollution control

The optimal level of pollution from society’s point of view is not zero, but is given by the level at which the marginal cost of pollution is equal to the private/social marginal benefit of disposing of waste by the cheapest method possible. Even though this prescription is theoretically precise, it is often very difficult to actually estimate the marginal social costs and benefits of pollution. Without government intervention, environmental pollution is certainly likely to be excessive.

There are generally two ways to achieve the optimal amount of pollution control: direct regulation and effluent fees. By direct regulation, government could legislate that the industry limits pollution to the optimal level. Alternatively, government could set the effluent fee that brings the private cost of pollution equal to its social cost. An effluent fee is a tax that a firm must pay to the government for discharging waste or otherwise polluting.

While direct regulation is sometimes necessary, economists generally prefer effluent fees to achieve optimal pollution control. There are two reasons for this. First, effluent fees generally require less information on the part of the government than direct regulation. Second, and more importantly, effluent fees minimize the cost of optimal pollution control, whereas direct regulation does not. This is because with effluent fees, each polluter will pollute until the marginal benefit of pollution equals the effluent fee. Thus, the optimal amount of pollution is allocated to those firms that benefit the most from polluting. As a result, the social cost of pollution is minimized.

One way to use effluent fees to reduce pollution is by the sale of pollution rights by the government. Under such a system, the government determines the amount of pollution that it thinks is socially tolerable (based on the benefits that result from the activities that generate the pollution) and then auctions off licenses to firms that generate pollution up to the specified amount. Pollution costs are thus internalized (i.e. they are considered part of regular production cost) by firms and the allowed amount of pollution is utilized in activities in which it is most valuable.

The industry/firm does not pay all social cost of its pollution, it does not consider profitable to reduce its pollution level up to the marginal level. The government may adopt various measures to make the firms reduce pollution. Some measures are as follows:
  1. Direct regulation: The first method used by the government to make the business firm reduce pollution is the direct regulation. If the firms or individuals break this law or discipline of the government are punished.
  2. Effluent fee: The government encourages the firms or individuals to reduce pollution by imposing effluents fee. The effluents fee may be useful in the certain area where it has to maintain quality of local rivers. This experiment may be very successful in a particular area. However, in case of Nepal, it is not applicable. Those who are making dirt in the public place but nobody charge them. In order to manage the dirt, or wasteful material goods, the government can levy the pollution tax.
  3. Issue of transferable emissions permits: By issuing transferable emissions permits, the government may reduce the quantity of pollution. Such permit allows creating pollution in the given quantity. It means permits are being issued in limited quantity. If it is done, the total quantity of pollution is equal to one determined by the government.

These permits can be purchased and sold. The firms, which consider it very expensive to reduce pollution, purchase such permits. On the other, the firms that consider it cheaper to remote pollution, sale the permits.

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Meaning of Market Failure | Ways of Correcting Marketing Failure | Utility Regulation

Market failure describes the circumstances in which distortions prevent the invisible hand from allocating resources efficiency. It covers all the circumstances in which equilibrium free unregulated markets i.e., markets not subject to direct price or quantity regulation by the government. The following sources of distortions can lead to market failure.

Is utility regulation an effective measure to respond to market failures? What are the sources of market failures? How does the government try to control it?

Competitive markets fail for four basic reasons: market power, incomplete information, externalities, and public goods. We will discuss each in turn.

i) Market Power

It has seen that inefficiency arises when a producer or supplier of a factor input has absolute market power. If a producer has monopoly power, it chooses the output quantity at which marginal revenue (rather than price) is equal to marginal cost and sets price on the basis of average revenue curve in that quantity, which is clearly higher than perfect competition price and output level is lower than output produced by the firm operating in perfect competition market. The lower output mean a lower marginal cost of food production. Meanwhile, the freed-up production inputs will be allocated to produce other commodities, whose marginal cost will increase. As a result, the marginal rate of transformation will decrease because MRTFC = MCa / MCb.

ii) Incomplete information

If consumers do not have accurate information about market prices or product quality, the market system will not operate efficiently. This lack of information may give producers an incentive to supply too much of some products and too little of others. In other cases, while some consumers may not buy a product even though they would benefit from doing so, others buy products that leave them worse off. Finally, a lack of information may prevent some markets from ever developing. It may, for example, be impossible to purchase certain kinds of insurance because suppliers of insurance lack adequate information about consumers likely to be at risk. Each of these informational problems can lead to competitive market inefficiency.

iii) Externalities

The price system works efficiently because market prices convey information to both producers and consumers. Sometimes, however, market prices always do not reflect the activities of either producers or consumers. There is an externality when a consumption or production activity has an indirect effect on other consumption or production activities that is not reflected directly in the market prices.

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Suppose, for example, that a steel plant dumps waste matter in a river, thus making a recreation site downstream unsuitable for swimming or fishing. There is an externality because the steel producer does not bear the true cost of waste water and so uses too much waste water to produce its steel. This externality causes an input inefficiency. If this externality prevails throughout the industry, the price of steel (which is equal to the marginal cost of production) will be lower than the cost of production reflected the waste matter cost. As a result, too much steel will be produced and there will be output inefficiency. Externalities have the following characteristics.
  • Externalities can be caused by the acts of individuals or by acts of institutions. For example, music clubs in students’ hostels are often accused of playing loud music, disturbing the peace that ought to prevail at night.
  • When externalities are generated, there arises a question that ought to own the property. In the example steel plant, there always arises a question who should own the ‘clean water.’
  • Externalities can be positive and negative.
  • Externalities, especially the negative externalities, cannot be done away with. For example, if we aim for one hundred percent clean air, there can be no factories and no production. A balance has to be struck between the benefits and costs of the activity before imposing restrictions.

iv) Public goods

The last source of market failure arises when the market fails to supply goods that many consumers value. Public goods can be made available cheaply to many consumers, but once it is provided to some consumers, it is very difficult to prevent from consuming it. For example, suppose a firm is considering whether to undertake research on a new technology for which it cannot obtain a patent. Once the invention is made public, others can duplicate it. As long as, it is difficult to exclude other firms from selling the product, the research will be unprofitable. Market therefore experiences undersupply of public goods. Government can sometimes resolve this problem either by supplying a goods itself or by altering the incentives for private to produce it. Some of the major characteristics of public goods are as follows:
  1. Non-rival: Public goods are non-rival in nature. A goods or service is non-rival if, even on consumption by some individuals, the quantity available for others is not reduced. The classic example of a service which is non-rival is the defense services. We do not get this character in private goods. For example, the purchase of a pair of shoes by one reduces the availability of shoes for others. This is because the marginal cost of providing shoes for an additional consumer is positive. Rival goods, therefore, get allocated to consumers, but in the case of non-rival goods, no such allocation is made, and they are available to everyone.
  2. Non-excludable: Unlike, private goods, public goods are non-excludable i.e., people cannot excluded from the consumption of such goods or services. 

A public good is, therefore, one that is non-rival and non-excludable, a good which can provide benefits to consumers at zero marginal cost, and no one can be excluded from its consumption. This makes price meaningless and a private producer will not enter an area where price does not exist. Hence, public goods are to be provided by the state.

Some goods are exclusive, but non-rival. A recreation park is non-rival, but entry into this park can be exclusive. Also, some goods are non-exclusive, but rival. The sea is itself non-exclusive but coral harvesting is a rival activity and so is fishing. Public goods are both non-rival and non-excludable.

Correcting Marketing Failure


If the firm that generating the externality has a fixed proportions of production technology, the externality can be reduced only by encouraging the firm to produce less. This goal can be achieved through an output tax. Fortunately, most firms can substitute among inputs in the production process by altering their choices of technology. For example, a manufacturer can add a scrubber to its smokestack to reduce emissions.

Consider a firm that sells its output in a competitive market. The firm emits pollutants that damage air quality in a neighborhood. The firm can reduce its emissions, but only at a cost.

We can encourage the firm to reduce emission to E* in three ways: (1) emissions standards, (2) emissions fees, and (3) transferable emissions permits. We will begin by discussing standards and fees and comparing relative advantages and disadvantages. Then we will examine transferable emissions permits.
  • Emissions standards: An emissions standard is a legal limit on how much pollutant a firm can emit. If the firm exceeds the limit, it can be monetary and even criminal penalties.
  • Emissions fee: An emissions fee is a charge levied on each unit of a firm’s emissions.
  • Transferable emissions permits: Transferable emissions permit is a system of marketable permits, allocated among firms, specifying the maximum level of emissions that can be generated. If we knew the costs and benefits of abatement and if all firm’s costs were identical, we could apply a standard. Alternatively, if the costs of abatement varied among firms, an emissions fee would work. However, when firm’s costs vary and we do not know the costs and benefits, neither a standard nor a fee will generate an efficient outcome.

We can reach the goal of reducing emissions efficiently by using transferable emissions permits. Under this system, each firm must have permits to generate emissions. Each permit specifies the number of units of emissions that the firm is allowed to put out. Any firm that generates emissions not allowed by permit is subject to substantial monetary sanctions. Permits are allocated among firms, with the total number of permits chosen to achieve the desired maximum level of emissions. Permits are marketable: They can be bought and sold.

Marketable emissions permits create a market for externalities. This market approach is appealing because it combines some of the advantages features of system of standards with the cost advantages of a fee system. The agency that administers the system determines the total number of permit and, therefore, the total amount of emissions, just as a system of standards would do. But the marketability of the permits allows pollution abatement to be achieved at minimum cost.

Utility Regulation


Some public utilities are publicly or municipally, owned – for example, water supply systems and sewerage systems. The proper scope of municipal ownership remains a subject of debate. The relative cheapness and efficiency of service coupled with local conditions are the chief factors to be considered in deciding between public and private ownership. Sufficient methods of financing municipally owned undertakings must also be planned so as not to increase municipal debt beyond prudent limits. In addition, recent changes in federal tax laws have made it more difficult for municipalities to raise capital for the acquisition of utility property through tax-exempt financing.

The vast majority of public utilities in the US are owned by private corporations. These private firms differ from other businesses in that utility companies are obligated to serve all who ask for their services and in that they must usually make a very large capital investment in relation to the revenues they receive.

Control of most public utilities lies with public service commissions, agencies formed to protect the safety of the people and property under their jurisdiction. These commissions operate at the federal, state and local levels, sharing the responsibility for determining rates and supervising the service provided. The grant by a governmental authority to a privately owned utility company giving the company the right to use public streets for placement of poles, wires, mains, tracks, and the like is called a franchise. Franchises are now extended to public utilities for a limited number of years, in contrast to the previous practice of unlimited franchises. Present franchises usually allow for governmental review of revenues, expenses and income; provide for arbitration of disagreements; and explain the conditions that must be met by the utility in order for it to retain the franchise. The purpose of granting a franchise is to protect the public interest and to allow the utility the right to use public property.

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