Negative Externality
Markets are not always efficient as there are many incidents where the resources are misallocated by the free market. This is a market failure which is characterized by externalities. Externality is the incidence of a spill over benefit or cost to a third entity in the economy who does not choose to incur the cost nor the benefit. When the external factor incurs a cost it is called a negative externality and if a benefit is derived from it, it is called a positive externality. In case of a negative externality, the Marginal Social cost involved in the production of the good is greater than the Marginal Private Cost of producing the same. Thus the society bears a higher cost than what the consumer bears as buyers decide on the basis of the marginal benefits and costs and of the social costs. In the recent times agriculture utilizes a lot of new technologies, heavy finances and non-renewable resources efficiently but they have considerable levels of negative impacts on the capital assets. These assets are not restricted to only soil and water but it includes other aspects like soil formation, nutrient cycling and its fixation, biological control, pollination and carbon sequestration. The main point is to understand if increase in the yield in agricultural production causes a cost to the environment coupled with health problems. By analysing the extent of market failure and costs in the sector properly, government agencies can attempt to overcome the tragedy of commons and reduce the negative externality. The negative externalities imposed by agriculture on the society are through land and use of other resources. These include erosion, biodiversity loss, water usage, subsidy payments nutrient runoff and pesticides. In an unregulated market there is an increased incidence of a negative externality as producers do not take the responsibility instead they pass it on to the society and in turn keep their marginal cost down. This way they can increase their volume of sale which in case of including social cost would have gone down and with that the profitability of the producers would also have fallen.
A negative externality occurs when an entity does not end up paying the full cost for the decisions it takes. The negative externality or the extra cost is generally borne by the society but being an integral part of the society, everyone indirectly ends up paying the social cost which is termed as an external diseconomy or external cost. If these costs were to be included by producers then the marginal cost of production for them would have gone up and hence hampered their profit (Mankiw, 2015). Externalities eventually lead to a market failure as the good or service’s price does not truly reflect its costs or benefits as equilibrium is meant to result from optimal production level. In the presence of externalities the equilibrium is flawed as there are additional incentives driving individual decisions. This ends up making everyone worse off and this is what a market failure essentially is. In case of a negative externality a market failure is an excess in the production volume at a price that does not only goes with the true cost of the production but also causes increased pollution. Being fully aware of externalities is very important to combat the problem of market failures and policymakers must adjust costs and benefits accordingly.
Impact of Negative Externality in Agricultural Sector
Pollution is the most common example for this and this has been considered in the perspective of the agricultural sector in India for this case study. Air borne pollution and water pollution due to fertilizers and pesticides arise from agricultural activities (Haldane, & Antle, 2015). It also has an effect on land use. Agriculture is an economy which is based on monsoons or rain water but irrigation also plays a significant role. Ground water has been the main source of irrigation over the last few decades and are done with the aid of different wells and water channels, this ground water is now facing scarcity due to over exploitation (Stirling, et al., 2018). This is a major negative externality in the agricultural marketing. Initially irrigation lead to improvement in agriculture, where 70% of food grains would come from irrigated land and 60% of the water used for irrigation came from ground water but its overuse lead to it becoming a scarce resource since the number of irrigation blocks are growing at a rate of 5.5% per annum (Arriaza, et al., 2015). This physical scarcity of water due to degradation and depletion will have a negative impact on the profits and productivity of the agricultural sector.
The rate at which ground water is exploited in India is much higher than the rate of creation of ground water where annually 43.57 million hectare-meter is the total quantity of replenishable ground water ad this quantity is very less given the demand for it in India and most off the water sources are owned by individuals or private firms (Bown & Hillman, 2016). This resource is facing the tragedy of the commons n the informal market because individuals just want to their profits through the exploitation of ground water which results in the society bearing a cost for exploitation but nobody reaps the advantage. There is a rapid and continuous shrink in the size of the wells which is affecting the environment along with the public and private sectors hence the proper management of ground water is crucial for the growth and development of the agricultural sector in India along with poverty alleviation which is also dependant on the irrigation situation (Bowe & van der Horst, 2015).
Figure 1: Negative Externality
Source: Mankiw, G. (2015)
In the diagram the axes represents price and quantity. The demand curve is the marginal social benefit curve. Additionally, the marginal social cost and the marginal private costs are also given. These act as the supply curves and reflect the quantity of goods supplied or consumed. The difference between the two curves that is the marginal social cost and the marginal private cost curve is the external cost. The producers should be producing Q1 amount of goods which would cost him P1 whereas he is producing Q quantity incurring a cost of P which is lower because he is enjoying an exemption of the social marginal cost because of the existence of negative externalities. That cost is being borne by the society. The shaded area represents the dead weight loss.
Government Initiatives to Solve Negative Externality
On applying it to the negative externality situation in the agricultural sector in India, the demand curve would represent the demand for irrigable ground water MPC is the supply curve at low cost that is without bearing social costs and MSC is the supply curve of ground water after including social costs. The deadweight loss or the shaded area is the cost that the society is facing while the farmers are consuming Q amount without paying social costs. The firm should be at the MSC curve but due to the presence of externalities it is on the MPC curve. This is giving rise to the deadweight loss which is being covered by the society.
Policy makers should subsidize markets facing positive externalities and penalize the ones causing negative externalities (Mogues, Fan, Benin, 2015). However they face the obstacle of not being able to quantify these externalities in order to increase or decrease the production. Different tools like mandates, taxes, penalties and incentives have been devised that would increase the cost to a company and result in a decrease in the negative externality.
There are many steps that can be taken up by the government which include regulating services that affect the climate and provisioning services. Market based policies help in the reduction of pollution under control as taxes as tax breaks discourage many polluters. The command and control policies pay very less attention to the information and inventive problems faced by the economy due to policies designed to reduce pollution (Bhargava, Lybbert & Spielman, 2015). When devising tax policies to reduce pollution, a corrective tax should be equal to the external cost and should consider quality and quantity. In India, the federal tax structure generates rich harvest with the addition of GST or the gods and services tax while the subsidy resources are taken from tax payers to compensate for the society’s cost (Pretty, 2018). The aim of correcting the external cost incurred and taxing the producer, consumer and society gets defeated (Pandey, et al., 2016). The government follows the legal method of command and control but researchers admitted that given the size of the country especially the rural side, imposition of command and control is difficult. Researchers also noted that irrigation is influenced by economic, social, political, geographical and region specific factors which is why government policies fail as they cannot judge the mind-set of the people. Several provisioning methods have also been taken up by the government to restore water like rejuvenation of water bodies, watershed program and rain water harvesting but not in a large scale. These methods are not adequate and therefore Coase theorem is more effective (Krupnik, et al., 2018). Therefore it has been argued that by abolishing taxes and promoting promotion of market competition will lower the overall cost to the consumers and the tax on the society. For instance having tradable water right regime would automatically adjust the scarcity in the water production. Research has shown that farmers near Malaprabha river basis in Karnataka are willing to pay rates higher than the government rates for water if they are guaranteed with reliable water for irrigation from other alternative institutions (Müller, Rommel & Kimmich, 2018). There exist some drawbacks like there is no proper way to measure transaction costs as there is asymmetry in the flow of relevant information and improvement in the flow of information will lead to the reaching of an equilibrium. This mechanism faces other disadvantages for example it does not insure that nobody gets deprived. For instance with the entry of imperfections like corruption, manipulation, coercion, undue influence and many more the market fails to perform efficiently (Reganold, & Wachter, 2016). Presently there is command and control over the supply of ground water but if the control is withdrawn by the government efficient maintenance of rules and regulations cannot be ensured.
Conclusion
Figure 2: Negative Externality with Government Intervention
Source: Mankiw, G. 2015.
The graph in figure 2 shows how taxation works. MSB is the demand curve or the marginal social benefit curve. The supply curves are denoted by MPC, MPC + TAX and MSC. The firm is supplying or consuming at MPC which is the marginal private cost. This is not inclusive of the cost that is being borne by the society for the production in this case for the usage of ground water for irrigation in the agricultural sector in India. The price incurred on the firm is P1 and consumes Q1 quantity of ground water. With the imposition of a tax by the government, the price rises to P2 from the previous lower price P1 and the supply curve shifts to the MPC+TAX curve from the previous curve MPC. The quantity produced also falls from Q1 to Q2 and the dead weight loss that the society faces has reduced and has been shown by the shaded area which is lesser than the area before the imposition of taxes as shown in figure 1. In an ideal situation, which should be at P* and Q* price and quantity combination, the marginal social cost gets fully covered. In this case MSC would be the firm’s supply curve which represents the marginal social cost incurred. Therefore after taxation the cost that the society incurs is given by the shaded area.
Besides government action it is very important to involve farmers as the development of ground water irrigation took place due to the presence of highly decentralized private farmers (Tripathi, Mishra & Verma, 2016). These farmers are using the natural resource extensively and irresponsibly, ignorant or unaware of the consequences of their actions because of which the whole society and country both the urban and rural India is facing severe water crisis. Water users are also not making any significant investment neither are the farmers or the government and so the water scarcity issue is also suffering the problem of lacking finance (Gautam & Yu, 2015). Financial scarcity is also a very huge cause behind the negative externality that the agricultural sector in India faces and due to lack of capital formation this problem is persisting.
There are many types of market structures existing in the economy that can be used to characterize an economy but the 4 four basic types of market structures have been discussed in this report.
- Perfect Competition: This is a market structure which has an infinite number of consumers and firms which are competing against each other. No individual firm has significant amount of market power and the industry produces at an optimal level as no single firms or households have the ability to have an influence on the market prices. It has many assumptions like all firms maximize profit, there is free entry and exit, all products sold are identical and there exists no consumer preference. This kind of market structure does not exist in reality.
- Monopolistic Competition: This is structure with a large number of firms competing against each other but unlike a perfect competition, the products sold in this market structure are slightly differentiated which gives the firms a certain degree of market power which enables them to charge higher prices but upto certain level. The assumptions of this market structure is that all firms maximize profits, there is free entry and exit, products sold are differentiated and consumer preferences may vary among different products. This market structure is comparatively more realistic, however it does not produce a socially optimum level of output. Here the firms have higher power and can influence the market prices to a certain extent.
- Oligopoly:In this market structure there are a small number of firms, typically 3 – 5 dominant firms, which leads to a limited amount of competition. These firms either compete against each other or collaborate and use their collective market power to shoot up the prices and earn profit. This market structure has a few assumptions too like all firms maximize their profits and can set their prices, there are barriers to entry and exit, the products may be differentiated or homogeneous and there are a few firms who dominate the market.
- Monopoly:This is a market structure where there is a single firm who has control over the market and has the highest degree of market power as the consumers do not have other alternatives for consumption. Monopolists often reduce output to raise their prices in order to earn more profit. The assumptions of a monopoly are that a monopoly maximizes his profit and can set his price, there are high barriers to entry and exit and there is only a single firm dominating the entire market.
The agricultural sector in India cannot be exactly categorised under any particular market structure but it has the closest resemblance to the characteristics of a perfect competition. However many of the assumptions have to be compromised in order to make the agricultural sector fit the perfect competition market structure (Pray & Fuglie, 2015). The assumption of a vast number of buyers and sellers in a perfect competition holds true in the case of the Indian market as it is huge and highly fragmented with innumerable participants. Since the capacity and the size of different farmers are diverse the assumption of the producers being of similar size and capacity in a perfect competition, does not hold true in India’s scenario. There are farmers in India who are extremely poor and are highly marginalised with a large number of farmers committing suicide because of being debt trapped. Conversely there are a number of land owners and firm house owners who are extremely rich. There is another assumption in a perfect competition which says that no one must be a price maker but a price taker. This assumption is also not met as there exist many business hoarders and agricultural houses who tend to enjoy a higher bargaining power in comparison to the rest. Therefore in the Indian scenario there are some price makers and some price takers. The government of India has set a minimum support price for several agricultural products but in several cases it has been seen that many of the farmers are unable to receive it (Gold, 2016). Perfect competition also assumes smooth information flow, especially information related to the market but that does not happen due to information blockage along with manipulation of prices as well as information.
Conclusion
Negative externalities take place in any given economy when there are a few costs that are incurred but not by choice and the economy has to pay for those costs for example pollution is a negative externality of several activities which are necessary for the functioning of an economy. The report analyse the agricultural sector of India and its negative externality. It showed how the producers produce only at the private costs and the pollution that the agricultural activities and cause other negative impacts caused are borne by the society. So here the marginal social cost is higher than the marginal private cost and the society has to bear the deadweight loss which leads to a fall in the overall social welfare of the country. The report has also discussed the fall in the level of ground water due to its intense usage for the purpose of irrigation to help in the proper functioning of agriculture. This over exploitation is leading to water crisis and the whole of India is suffering because of the crisis caused by one sector namely the agricultural sector. Several attempts have been made by the government to address this problem using different policy measures. Command and control was taken up along with that the government also took up provisioning which included rain water harvesting and many such initiatives. However none of these efforts seemed to bring success or solution to the problem and the reason why they were inadequate was due to the lack of finances. Along with increasing the finances, the report also suggests that if the government can ensure property rights then by the method of market mechanism this negative externality can be successfully be addressed and the country might be able to overcome this crisis.
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