The Theory of Externality

This article discusses negative externalities arising from production, specifically sewage wastes from cruise ships. It explains how negative externalities lead to market inefficiencies and suggests solutions such as extension of property rights, taxing the polluters, use of subsidies, and government regulation. The article also includes a supply and demand curve to illustrate the negative production externalities.

Running Head: Externality 1
THE THEORY OF EXTERNALITY
Student Name
Professor
Institution Name

Running Head: Externality 2
Introduction
When the cruise ships release sewage into the ocean, this causes water pollution which is
under negative production externalities. A negative externality is the cost which the third party
suffers as a result of economic transaction. The second parties in the production are producers
and consumers while third parties are the individuals, societies, firms or resources that are
affected (De Nicolo, 2012). This task will describe the negative externalities that occur due to the
release of sewage into the oceans by the cruise ships. It will also analyse the solutions to the
externalities with relevant supply and demand curves.
Negative externalities
These externalities are also called external costs. Externalities arising from consumption
include wastes while externalities arising from production include emissions from factories. In
our case, we will look at production externalities which are the sewage wastes from the cruise
ships (Rezai, 2012). When the property rights over assets or resources are not certain, then it
leads to externality. Example of this is when these cruise ships release the sewage into the oceans
they do not fear doing this because the oceans have no property rights as they are public
resources (Kremen, 2012).
Negative externalities occur when individuals or firms who make decisions do not have
to pay a full cost for such decisions. A good having a negative externality makes the society to
pay more costs than the consumers (Spulber, 2012). These negative externalities lead to market
inefficiencies when no action is taken to solve the problem. In case a negative production
externality occurs, the producers take no responsibility for the external costs that arise and hence
the society has to pay for such costs (Kuwayama, 2013). This makes the marginal cost of the
producers to be lower and the supply curve shifts down to the right.
When a ship releases sewage into the oceans, water is polluted and this makes the people
living around the ocean to pay for pollution and death of marine animals. This is because they
incur high medical expenses and poor quality of air. There is a negative cost to the individuals
living around the ocean which the cruise ships do not pay (Wertzman, 2014). Cruise ships
release large numbers of sewage wastes, wastewater from sinks and showers, hazardous wastes
and air pollution (Kuwayama, 2013).

Running Head: Externality 3
The diagram below is a supply and demand curve that illustrates the negative production
externalities in the case of the cruise ships releasing the sewage wastes into the oceans.
(Wertzman, 2014).
According to the diagram, we have compared the social cost and social benefit where
individual demand is represented by the social benefit (SB) (Kuwayama, 2013). The social
cost(SC) curve is higher than the supply curve(S). this is because the external cost(EC) is not
included in supply decision of the cruise ship. In this case the optimal market situation(O) is
different from the market equilibrium(E) hence an oversupply of harmful behavior. In our
example above, the price of optimal good is higher than the actual market prices of the goods
(Spulber, 2012).

Running Head: Externality 4
Solutions
Extension of property rights
People may be given ownership rights over their environment and this will make them to
enforce environmental policies and other standards (Spulber, 2012).
Taxing the polluters
The use of taxation is the best solution to solve negative externalities. Taxing a good
makes the costs of the producer to rise hence shifting the supply curve to the left (Young, 2010).
The producer has the burden to pay the tax bill even though the producer may increase prices to
the consumers. Allowing taxes to the producers and consumers make them allow for the
externality in decision making (Kremen, 2012). The only problem with imposing taxes is that the
government finds it difficult to measure the size of the externality (De Nicolo, 2012).
Use of subsidies
The government can also pay subsidies to the producers so as to increase the output of the
goods (Spulber, 2012). The supply curve will shift to the right leading to higher output and lower
prices.
Government regulation
The government can also use legislation measure to control these pollution levels. It may
be difficult when the legislation causes 50 million euros benefits but administering it costs 60
million euros. Hence the government finds it difficult to get the balance right (Lehmann, 2012).
The government can set legal limits or regulations so as to either prevent these negative
externalities or reduce their effects (Rezai, 2012).
Conclusion
A negative externality is the cost which the third party suffers as a result of economic
transaction. Externalities arising from consumption include wastes while externalities arising
from production include emissions from factories. A good having a negative externality makes

Running Head: Externality 5
the society to pay more costs than the consumers. These negative externalities lead to market
inefficiencies when no action is taken to solve the problem. In case a negative consumption
externality occurs, the producers take no responsibility for the external costs that arise and hence
the society has to pay for such costs. The government can use subsidies, taxes, legislations and
also property rights to reduce or control negative externalities.

Running Head: Externality 6
References
De Nicolo,M.G.,Favara,G., &Ratnovski,L. (2012). Externalities and macroprudential policy.
International Monetary Fund.
Kremen, C.,&Miles,A. (2012). Ecosystem services in biologically diversified versus
conventional farming systems:benefits, externalities and trade-offs. Ecology and
Society,17(4), 12-20.
Kuwayama, Y.,&Brozovic,N. (2013). The regulation of a spatially heterogenous
externalty:Tradable groundwater permits to protect streams. Journal of Environmental
Economics and Management,66(2), 364-382.
Lehmann, P. (2012). Justifying a policy mix for pollution control: a review of economic
literature. Journal of Economic Surveys,26(1), 71-97.
Rezai, A.,Foley,D.K.,&Taylor,L. (2012). Global warming and economic externalities. Economic
Theory,49(2), 329-351.
Spulber, N., &.Sabbaghi,A. (2012). Economics of water resources:from regulation to
privatization(vol.13). Springer Science & Business Media.
Wertzman, M.L. (2014). Can negotiating a uniform carbon price help to internalise the global
warming externality? Journaal of the Association of Environmental and Resource
Economists,1(1/2), 29-49.
Young, R.A. (2010). Determining the economic value of water:concepts and methods .
Routledge.