Negative Externality and Market Failure in Indian Petrochemical Industry

This essay discusses negative externality and associated market failure in reference to a real world industry, Indian Petrochemical industry. The essay also talks about government measures to address externality and suggests policies to address negative externality.

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Economics for Managers
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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 and market failure
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.

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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).

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Figure 1: Negative externality and marginal cost
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.
Negative externality: A case study of Indian petrochemical industry
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

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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
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.
Hazards associated with petrochemical and subsidiary industry
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

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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.
Table 1: Wastes from Indian refinery
(Source: environmentalpollution.in, 2018)
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)

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Toxic Pollution load Water Pollution load
0
20000
40000
60000
80000
100000
120000
140000
160000
12605 6730
26795
14307
147039
73168
Toxic and Water polltion
1991 2001 2011
Figure 2: Toxic and water pollution load overtime
Government measure to address externality
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.
Polluter pay principle
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

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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.
Carbon tax
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.

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Table 2: Domestic petroleum tax on in major nations
(Source: economictimes.indiatimes.com, 2018)
Figure 3: Effect of a tax on carbon production
The figure above shows that 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

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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.
Figure 4: Hierarchy of Environmental mitigation measures in India
(Source: Ma, Meng & Liu, 2016).
Suggested policies to address negative externality

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Market based economic instrument
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.
Figure 5: Impact of pollution charge or tax
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).
Innovating funding mechanism

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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.
Figure 6: Market for tradable pollution permit
Cleaner production
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.
Market Structure
The four main forms of market structures are perfect competition, monopoly, monopolistic
competition and oligopoly.
Perfect competition

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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
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
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

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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.
Oligopoly
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),

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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.
Economic efficiency
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.

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Figure 7: Economic efficiency in perfectly competitive market
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.

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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.

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