How Market Failure and Externalities Contribute To Environmental Problems

Market failure is characterized by inefficient distribution of services and goods in a free market. Externalities arise when a service or good’s consumption harms or benefits a third party. For example, pollution from producing a specific product is considered a negative externality because it hurts communities and individuals. The collateral damage arising from negative externalities contributes to market failure. Externalities may also cause market failure when the price equilibrium of products and services in the market does not accurately reflect the true benefits and costs of the service or product. Over the past decade, there have been concerns about the impact of business activities on the environment due to increased environmental pollution and the issues linked to environmental pollution, such as climate change and global warming. This report reviews how market failure and externalities contribute to environmental problems.

Market Failure, Externalities and Their Contribution to Environmental Problems

Market failure creates an imbalance in the demand and supply of products, thus creating a need for change in business regulations to sustain businesses that contribute to economic growth. In such instances, the government may reduce or remove negative externalities causing market failure by reducing taxation on raw materials. For example, the government may reduce taxation on fossil fuels leading to an increase in the use of fossil fuels which are among the leading causes of environmental pollution. The government may also reduce regulations on gas emissions, thus encouraging organizations to continue emitting gases that pollute the environment during their production processes. According to Gillingham & Sweeney (2010), there is evidence of environmental externalities from producing renewable energy, such as hydroelectric plants that produce carbon dioxide and methane emissions from submerged vegetation, nitrogen fertilizer runoff from ethanol biofuel production, or greenhouse gas emissions. These externalities contribute to environmental pollution and may discourage firms from using renewable energy. Government regulation may also impact waste disposal strategies used by manufacturing firms based on the cost of disposing of waste. When the cost of disposing of the waste from the production process is high, firms may look for cheaper alternatives, including disposing of waste in open fields, thus creating environmental pollution and putting the health of those around the waste disposal sites at risk.

According to Gillingham & Sweeney (2010), environmental pollution could arise from information market failure relating to the use of renewable energy, such as wind and solar energy. Information market failure may arise when one party can access information that the other party does not when agents fail to disclose all information needed to make an economic decision when the information shared in the market is false, and when a firm has information bias (Belay, 2017). Environmental pollution may arise when firms have limited information about the measures they can take to ensure they do not pollute the environment. For example, when a firm does not have information about reusable and recyclable packaging material, proper waste disposal strategies, and how to limit emissions and energy consumption, it may increase environmental pollution. Lack of information can also cause firms to make imperfect predictions about their energy consumption and emissions, thus exceeding the required levels. Information market failures also increase environmental pollution when regulators dealing with monopolies use information bias to protect monopolies. For example, oil mining regulators may ignore information about the impact of fracking on the environment to protect monopoly oil mining companies that sustain the oil market, thus encouraging environmental pollution.

Market failure and externalities may also cause environmental problems when permit markets are used to control business activities. According to Sošić (2023), permit markets include issuing pollution permits to organizations in an industry that plans to reduce emissions. The permits give organizations the right to release emissions based on the number of permits they have. Permit markets place some organizations within the same industry at a disadvantage because some organizations are not in a position to pollute as much as their maximum production allows. Such firms seek ways to release emissions without being noticed, leading to increased environmental pollution. For example, firms may opt to release emissions if their emissions exceed the permit leading to unregulated emissions that could contain poisonous gases. According to Lapan & Sikdar (2017), globally tradable emission permits increase pollution compared to nontradable permits because of the lack of incentive to increase the strictness of the pollution policy for trade advantage purposes. Therefore, pollution permits provided to sustain industries and prevent market failure could be a leading cause of environmental problems arising from air pollution. The government could also knowingly ignore environmental protection regulations to help people earn a decent income. According to Hackett (2019), governments may be reluctant to apply environmental taxes to avoid reducing the income related to the factors of production used to produce products that harm the environment. When firms are not charged environmental taxes, they increase the manufacturing of goods that are not environmentally friendly leading to environmental harm.

Market failure and externalities may create stiff competition for organizations joining the market, forcing them to take shortcuts that could create environmental pollution. For example, manufacturing firms joining a competitive market may opt for cheaper raw materials and bypass pollution regulations to reduce operating costs. For example, firms may use cheap non-renewable, and non-reusable packaging materials such as plastics to reduce production costs. Stiff competition may also affect competition for production factors. For example, the rise of many firms offering the same products also increases competition for natural resources leading to environmental harm. For example, the competition for natural resources such as minerals increases mining activities leading to soil contamination, loss of biodiversity, soil erosion, contamination of groundwater, and loss of biodiversity. According to Riley (2016), large-scale gold mining in Ghana is the leading cause of acid rain, damaging vegetation and risking people’s lives. Government regulation may be ineffective in preventing the depletion of natural resources and the harm caused by mining companies to the environment because the minerals contribute to economic growth.

Conclusion

Environmental pollution and harm have raised global concerns because of increased global warming and climate change. The leading cause of environmental harm and pollution is business activities. The relationship between environmental pollution and business activities is evident in the impact of market failure and externalities on environmental harm. Market failure and externalities cause environmental harm by facilitating the reduction of the cost and taxation on fossil fuels, reduction in the regulations on gas emissions, increasing the cost of waste disposal, limiting the availability of information on measures that can be taken to protect the environment and creating information bias on information about environmental regulations. Permit markets created to deal with market failure and externalities also cause environmental harm by increasing the emission of poisonous gases. Environmental harm linked to market failure and externalities could also arise from stiff competition for resources and ineffective government regulation, particularly when the government ignores environmental regulations to secure income related to factors of production.

References

Belay, D. G. (2017). Economics of information and incentives in the regulation of market failure. The University of Copenhagen, Faculty of Science, Department of Food and Resource Economics.

Gillingham, K., & Sweeney, J. (2010). Market Failure and the Structure of Externalities. Yale School of Environment. https://doi.org/https://environment.yale.edu/gillingham/GillinghamSweeney_MktFailureStructureExternalities_proof.pdf

Hackett, S. C. (2019). Externalities, market failures, and policy interventions. Environmental and Natural Resources Economics, 66–87. https://doi.org/10.4324/9781315289939-4

Lapan, H. E., & Sikdar, S. (2017). Is trade-in permits good for the environment? Environmental and Resource Economics, 72(2), 501–510. https://doi.org/10.1007/s10640-017-0202-z

Riley, G. (2016). Externalities – gold mining in Ghana Hurts Farm Productivity. tutor2u. https://www.tutor2u.net/economics/blog/externalities-gold-mining-in-ghana-hurts-farm-productivity

Sošić, G. (2023). Stable linking of the emission permit markets. Sustainability, 15(6), 5393. https://doi.org/10.3390/

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