Externality in economics is defined as the added cost or benefit of an economic transaction that influences a third party who does not involve in the activity. Economic transactions that incurs an external cost is said to constitute negative externality. Positive externality on the other hand is the additional benefit enjoyed by the society. Both type of externality hampers the efficient functioning of free market. The problem is that private parties do not account the external cost or external benefit of the activity (Iossa & Martimort, 2015). In a free market, goods constituting external cost or external benefits are either overproduced or under produced.
The essay aims to discusses negative externality and associated market failure in reference to a real world industry. The specific industry chosen for the assignment is Indian Petrochemical industry. The single industry is responsible for causing considerable pollution in land, air and water. Some measures have been taken by the government to address the externality in the particular industry. In reference to degree of competition, markets are classified into four major categories, each having its own specification (Cowell, 2018). The market structure of Indian petrochemical industry is largely an oligopoly market. The presence of market power and collusive behavior of dominant players in the industry results in inefficient market outcome.
Negative externality arises when an individual or firm does not bear the full cost of a particular decision. This is an external cost imposed on a third party, neither directly nor indirectly related to the transaction. In the presence of negative externality, society bears the additional cost of the activity. In an unregulated market, such costs are not reflected in the market price. In the free market, decision of buyers depends on the associated marginal benefit and marginal cost of the activity.
If a market with negative externality left unregulated then external cost continues to be increasing. Producers are not generally willing to take responsibility of the external cost of production. They just pass on the cost to the society. The suppliers keep the marginal cost relatively lower by ignoring the social external cost. This allows them to produce a higher quantity above the socially efficient quantity (Kolmar, 2017). If the producers take into account the external cost then marginal cost would be higher interrupting profitability. The negative externality raise social cost above the private marginal cost.
Social Cost = Private Cost + External Cost
As the social cost is higher than private cost, free market fails to ensure efficient allocation of resources leading to market failure. Under this situation the private firm produces output higher than that socially desired. Government intervention is needed in such circumstances to correct the negative externality and restore market efficiency.
A common example of negative externality is pollution. For example, thermal power plants are associated with emission of a lot of pollutant to the air and ground. Because of pollution people living in the nearby location suffers from severe health diseases. The plant owners however do not bear the cost of health hazards or any other external cost. Unless government regulation such plants continue to emit pollutants (Hill & Schiller, 2015).
In the above figure, the horizontal and vertical axes represent quantity and prices respectively. The demand curve or marginal benefit curve is given as D. Because of negative externality the marginal social cost is different from marginal private cost. S1 presents the private marginal cost. The social marginal cost is given as S. If X is the external cost, then social marginal cost = Private marginal cost + X. The free market equilibrium occurs at O (intersection of private marginal cost and marginal benefit). Under free market, Q1 amount of output would be produced. The socially efficient output however is at Q (intersection of social marginal cost and marginal benefit). There is thus overproduction of goods because of negative externality. The cost on society or welfare loss is given by the area of triangle MNO.
Most industries are associated with one common form of externality called pollution. Chemical industry in India is one of the most pollution generating industry imposing a negative externality on the environment. India is known for having a large and advanced chemical industry among the developing nations. The industry has various subsectors engaged in production petroleum product, fertilizers, pharmaceuticals, pesticides and different organic and inorganic chemicals. The industry discharges harmful toxic chemicals leading to destruction of soil, vegetation and water. The chemical plants even release cyanides which caused 50000 fish water to die in Meerut Kai River in the year 1984 (environmentalpollution.in, 2018).
Petrochemical industry is one of the important industries in Indian. Indian petrochemical industry constitutes 2 percent of global market. The industry accounts a growth rate of nearly 10 percent. Producing a wide variety of product, the industry incurs profit of around 14 percent (business.mapsofindia.com, 2018). However, despite having positive contribution to economic growth the sector an adverse impact on environment quality.
The waste generated from petrochemical industry is injurious to health as it contains several harmful substances. This imposes an external cost on standard of living and environment. The discharged waste has an unfavorable impact on environment and lead to air, water and soil pollution. An important pollutant component emitted from petrochemical industry is aromatic components. The aromatic compounds from the industry introduces into the environment through leaks of natural oil, waste product and emission from industries, waste released during oil shortage, industrial effluents, spills from oil tanker, processing waste and others (Saxena & Singh, 2017). The main elements of petrochemical industries causing air pollution are Sulphur oxides and other compounds made of Sulphur, nitrogen oxide and other nitrogen compounds, Halogens and its components, different volatile organic compounds (VOC) and particular matter such as dust, soot, heavy metal and alkali. The major category of air pollutants in the petrochemical industry are combustion emission, acid gases and VOCs.
Wastes from petroleum and refineries industries vary as the industry and each pollutant constitute individual problem. The pollutants however can be classified based upon some common characteristics (Selvam et al., 2017). The nature of waste varies depending on type industry types, process used and type of process water utilization.
The statistics for toxic and water pollution is presented in table 2
Table 2: Toxic and water pollution (In metric tonnes)
|
Year |
Toxic Pollution load |
Water Pollution load |
|
1991 |
12605 |
6730 |
|
2001 |
26795 |
14307 |
|
2011 |
147039 |
73168 |
(Source: Saxena et al., 2017)
Without active intervention by the government the externality cannot be corrected. Following measures are taken by the government to control pollution caused by the petroleum industry.
The principle of polluter may ensure that the party responsible for generating pollution bear the entire cost of pollution. The party thus accounts for the environmental damage caused from the economic transaction. India in recent days, is highly relying on polluter pat principle to internalize the external cost of pollution. As per this principle, government has no responsibility either preventing or taking remedial action in response to environmental damage rather the burden is shifted on those who create the damages (Ambec & Ehlers, 2016). The Polluter Pay Principle seems to be sound policy for safeguarding environment by Court in Indian Council. The court is of the view that any principle taken to address externality is simple, practical suitable for obtaining the targeted condition in the country. There are various companies that discharges hazardous waste into the environment and polluting the nearby areas. The government ensures that any project in this industry should consider the damages caused to the environment (legalserviceindia.com, 2018). Additionally, many proponent of environment suggest that a good design of policy and proper management of environment impact is an effective tool for improving environment performance.
In order to reduce air pollution and prevent changes in climatic condition, government adapts the policy of high petroleum taxation. This helped India to gain an edge over other major economies in world in terms of fighting with change in climatic condition. The excise duty on the branded petroleum has increased from Rs.15.5 per liter in 2014. The diesel tax has also been increased from Rs.19.7 per liter (economictimes.indiatimes.com, 2018). The hike in petroleum tax has been more than 150 percent in India. At present, India outperforms all the major European nations in terms of petrol and diesel tax.
The effect of carbon tax with the help of economic theories of demand and supply. The upward sloping curve shows the carbon supply curve while the downward sloping curve indicates the demand for carbon. An imposition of tax shifts the supply curve upward. After the tax, new price would be old price plus amount of tax. The new equilibrium point is at B with a higher price P1 and targeted reduced quantity of Q1.
The 2-T oil (Regulation of Supply and Distribution) order, 1998
With the objective of protecting environment government has adapted measure to restrict buying and selling of 2-T oil. 2-T oil is one form of lubricating oil that is used is vehicles running with 2-stroke petrol. The law extends to the National Capital Territory in Delhi. The law states that no person is allowed to sell or dispose of lose 2-T oil for use in a service garage of 2-T stroke vehicles (envfor.nic.in, 2018). In authentic petrol station, the special kind of lubricating oil (2-T) should be sold in a pre-mixed condition with petrol through nozzle.
Suggested policies to address negative externality
The market based regulatory instrument aims to address the problem of externality through using market signal. Policies such as pollution charges, tradable permits and others are used to bind market forces. The two market based regulation for negative externality is discussed below
Pollution charge: Under this system a specific fee or tax is imposed on pollution that a firm generates. Firms reduce pollution up to point where the cost of abatement equals tax rate. The degree of pollution control varies among firms (Gerardi et al., 2015). Those having a high cost of abatement reduces pollution less while those with lower abatement cost reduces more.
Tradable permit: The tradable pollution permit system allows firms to resale their permits if they can reduce the pollution level below the permitted one. Those who incur a higher abatement cost are buyers of the permit (Mazzucato, 2016).
There are many international forums that makes funds available for environment concern. Incentives should be taken at local level to increase funding for pollution control. There are other options through which funds can be raised for controlling pollution. Funds are raised automatically if government imposes pollution charge or tax (Ma, Meng & Liu, 2016). The funds should be utilized properly for purpose of environment protection.
Promotion of clean production has useful implication for controlling environmental pollution. Principles of cleaner production implies promotion of production of desired level of output by optimizing use of raw material along with minimizing pollution as much as possible.
The four main forms of market structures are perfect competition, monopoly, monopolistic competition and oligopoly.
Perfectly competitive market structure is a form of market where large number of buyers and seller present in the market selling a homogenous product.
In a perfectly competitive market, large number of sellers compete in the market place. Firms in a perfectly competitive market produce and sell identical products. This means the products are perfect substitutes. For this reason, firms face an infinitely elastic demand curve. Firms face no restriction for entry or exit the industry. As demand is independent of price, both marginal revenue and average revenue equal price. In the short run, equilibrium is obtained where price equals marginal cost (Jain & Ohri, 2015). Competitive firms in the short run can enjoy a supernormal profit or economic loss. In the long run however free entry or exit mechanism eliminates all profits and losses in the industry and firms enjoy only normal profit.
Monopoly is a specific form of market where single seller controls the entire market. In the monopoly market, the single firm has the full control in the market. The monopolist enjoys significant market power and influences both price and quantity. In this market, new firms face considerable barrier to enter the market. Entry barriers exits in the market in the form of government regulation, license, and requirement of huge capital, economies of scales or complex technology (Grubb, 2015). The monopolist sells a unique product that means no close substitutes are available for the product sold in the market. The single firm by using its market power can enjoy an economic profit both in the short run and long run.
Monopolistic competition is a form of market that possess the combined characteristics of both competitive and monopoly market. Like perfectly competitive market large number of buyers and sellers are present in the market. However, like perfect competition products sold in monopolistic competition are not perfect substitute rather these are close substitutes. Each firm differentiates its product to make its product different from others. In the short run, firms in monopolistic competition can earn an economic profit or economic loss (Stiglitz & Rosengard, 2015). In the long run however free entry or exits of firms however reduces economic profit or loss and firms earn only normal profit in the long run.
A fourth form of market is oligopoly market. The oligopoly market is characterized with the dominance of few sellers in the market. The most important feature of this market is interdependence among the firms. That is strategy of one firm depends on the strategy of others. The dominant firms in the oligopoly market creates considerable barriers to the entry of new firms. The oligopoly market is of two types – collusive and non-collusive oligopoly. In the collusive oligopoly the dominant firms collude and takes joint decision regarding price and industry output. The short run and long run profit in the market depend on the particular model of oligopoly (Parenti, Ushchev & Thisse, 2017).
Market structure of an industry is determined from the composition of firms in the industry. Number of firms in a specific industry determines the market power of individual firm. The petrochemical industry is classified as a homogenous oligopoly. It is homogenous because product differentiation is insignificant. The industry supplied non-branded, homogenous and intermediate inputs. In the petrochemical industry, presence of increasing return to scale, operation at a high scale and high investment cost results in market concentration limiting competition in the market. The four main players in the industry dominates the industry. Four dominating companies in the industry are Indian Petrochemical Corporation Ltd (IPCL), Reliance Industries Ltd (RIL), Haldia Petrochemical Ltd (HPL) and Gas Authority of India Ltd (GAIL). RIL and IPCL alone account 70 percent of the industry (Jafarinejad, 2017). In the downstream sector of petroleum industry especially in polyester is fragmented among 40 companies.
In an oligopoly industry neither productive nor allocative efficiency is achieved. Productive efficiency of a firm is associated with the production at the minimum point of average cost. The allocative efficiency on the other hand is determine from the operation of a firm corresponding to a point where marginal benefits equals marginal cost. Dominance of few firms in the industry gives the major players considerable market power such that they can charge a price above the marginal cost (Stiglitz & Rosengard, 2015). Profit maximizing output in the oligopoly market is not same as that of socially efficient output which is output corresponding to minimum point of average cost.
A source of inefficiency in the market is the formal or informal collusion among the firms. Collusion enables the firms to make price and output decision similar to that of a pure monopolist. The dominant companies in the industry involve in tacit collusion and charge same price. Coordinate price movement is an important feature of the industry. The Indian Oil Corporation, BPCL and HPCL involve in cartelization and constitute similar price movement (thehindubusinessline.com, 2018). The cartel like behavior was noticed by Competition Commission of India. However, the practice of coordinated price movement continues in an era of deregulation leading to economic inefficient outcome.
In contrast to oligopoly market, the perfectly competitive market is associated with an economically efficient outcome in the sense of both productive and allocative efficiency. Allocative efficiency is achieved as market price always equals marginal cost. In the long run firms operate at the minimum point of average cost yielding productive efficiency (Jain & Ohri, 2015).
In a market with negative externality, the marginal social cost is equivalent to marginal private cost plus the external cost. As marginal private cost is smaller than marginal social cost, the market is always oversupplied. Petrochemical industry in India is one of the most profitable industry that accounts a fast growth rate over time. The concerned industry however is responsible for causing significant pollution of land, air and water. Hazardous chemical substances discharged from the factories into the river.
Volatile organic chemicals, acid gases, Sulphur, Nitrogen and other oxides are some of the harmful pollutants released from these factories. The pollution imposes an external cost to the society in the form of severe diseases, change in climatic condition and overall deterioration of environmental quality. Government attempts to internalize the external cost through implementation of various regulation. Under the polluter pay principle, the agent needs to account for the entire cost of pollution. The market based approach to the externality problem can either be imposing a fee or tax or be restricting emission through tradeable pollution permits. The petrochemical industry has four dominants players shaping the market similar to that of an oligopoly market. Market power of large player prevent the market to be economically efficient.
References
Ambec, S., & Ehlers, L. (2016). Regulation via the Polluter?pays Principle. The Economic Journal, 126(593), 884-906.
business.mapsofindia.com. (2018). Petrochemical Industry and Environment. Retrieved from https://business.mapsofindia.com/india-petroleum-industry/petrochemical-and-environment.html
Cowell, F. (2018). Microeconomics: principles and analysis. Oxford University Press.
economictimes.indiatimes.com. (2018). Economic Survey: India’s high petroleum taxation helped gain edge on climate front – ET EnergyWorld. Retrieved from https://energy.economictimes.indiatimes.com/news/oil-and-gas/economic-survey-indias-high-petroleum-taxation-helped-gain-edge-on-climate-front/56891239
envfor.nic.in. (2018). 2-T Oil (Regulation of Supply and Distribution) Order, 1998. Retrieved from https://envfor.nic.in/legis/others/2t_oil.html
environmentalpollution.in. (2018). 4 Major Industries that are Responsible for Causing Pollution. Retrieved from https://www.environmentalpollution.in/industrial-pollution/4-major-industries-that-are-responsible-for-causing-pollution/1819
environmentalpollution.in. (2018). Top 6 Types of Chemical Industries | Pollution. Retrieved from https://www.environmentalpollution.in/industrial-pollution/top-6-types-of-chemical-industries-pollution/2259
Gerardi, K., Rosenblatt, E., Willen, P. S., & Yao, V. (2015). Foreclosure externalities: New evidence. Journal of Urban Economics, 87, 42-56.
Grubb, M. D. (2015). Overconfident consumers in the marketplace. Journal of Economic Perspectives, 29(4), 9-36.
Gugler, K., & Szücs, F. (2016). Merger externalities in oligopolistic markets. International Journal of Industrial Organization, 47, 230-254.
Hill, C., & Schiller, B. (2015). The Micro Economy Today. McGraw-Hill Higher Education.
Iossa, E., & Martimort, D. (2015). The simple microeconomics of public?private partnerships. Journal of Public Economic Theory, 17(1), 4-48.
Jafarinejad, S. (2017). A Comprehensive Study on the Application of Reverse Osmosis (RO) Technology for the Petroleum Industry Wastewater Treatment. Journal of Water and Environmental Nanotechnology, 2(4), 243-264.
Jain, T. R., & Ohri, V. K. (2015). Principal of Microeconomics. FK Publications.
Kolmar, M. (2017). Principles of Microeconomics. Springer International Publishing..
legalserviceindia.com. (2018). Interpretation of Polluter Pays Principle (PPP) In India. Retrieved from https://www.legalserviceindia.com/article/l54-Interpretation-of-Polluter-Pays-Principle.html
Ma, Y., Meng, Q., & Liu, Y. (2016). Problems and Countermeasures about Social Capital’s Participating in Water Pollution Control PPP Project. Open Journal of Social Sciences, 4(08), 91.
Mazzucato, M. (2016). From market fixing to market-creating: a new framework for innovation policy. Industry and Innovation, 23(2), 140-156.
Nava, F. (2015). Efficiency in decentralized oligopolistic markets. Journal of Economic Theory, 157, 315-348.
Parenti, M., Ushchev, P., & Thisse, J. F. (2017). Toward a theory of monopolistic competition. Journal of Economic Theory, 167, 86-115.
Saxena, A. K., & Singh, N. (2017). Indian Petrochemical Industry Challenges and Opportunities. Imperial Journal of Interdisciplinary Research, 3(8).
Selvam, S., Ravindran, A. A., Venkatramanan, S., & Singaraja, C. (2017). Assessment of heavy metal and bacterial pollution in coastal aquifers from SIPCOT industrial zones, Gulf of Mannar, South Coast of Tamil Nadu, India. Applied Water Science, 7(2), 897-913.
Stiglitz, J. E., & Rosengard, J. K. (2015). Economics of the public sector: Fourth international student edition. WW Norton & Company.
thehindubusinessline.com. (2018). Smash the PSU oil cartel. Retrieved from https://www.thehindubusinessline.com/opinion/columns/raghuvir-srinivasan/smash-the-psu-oil-cartel/article7170799.ece
Essay Writing Service Features
Our Experience
No matter how complex your assignment is, we can find the right professional for your specific task. Contact Essay is an essay writing company that hires only the smartest minds to help you with your projects. Our expertise allows us to provide students with high-quality academic writing, editing & proofreading services.
Free Features
Free revision policy
$10Free bibliography & reference
$8Free title page
$8Free formatting
$8How Our Essay Writing Service Works
First, you will need to complete an order form. It's not difficult but, in case there is anything you find not to be clear, you may always call us so that we can guide you through it. On the order form, you will need to include some basic information concerning your order: subject, topic, number of pages, etc. We also encourage our clients to upload any relevant information or sources that will help.
Complete the order form
Once we have all the information and instructions that we need, we select the most suitable writer for your assignment. While everything seems to be clear, the writer, who has complete knowledge of the subject, may need clarification from you. It is at that point that you would receive a call or email from us.
Writer’s assignment
As soon as the writer has finished, it will be delivered both to the website and to your email address so that you will not miss it. If your deadline is close at hand, we will place a call to you to make sure that you receive the paper on time.
Completing the order and download