The Theory of Externality

Running Head: Externality 1
THE THEORY OF EXTERNALITY
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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).