3000 firm’s profits could help society

A recent UN study on pollution has shown that if the 3000 largest firms would have paid their social costs than one third of their profits would have been lost and gone to protecting the environment.

Market failure exists when an unregulated market under or over allocation of resources towards a good or service. In this case a demerit good is over allocated towards the production of a particular product. Demerit goods are goods over-provided or over allocated by the free market, examples include, cigarettes and alcohol as well as pollution. Government need to regulate the production of demerit goods through taxation or limiting output of a firm.

During an economical transaction, the firm emits costs and benefits towards society and itself. During production the firm has two costs, marginal social cost, MSC, and marginal private costs, MPC. The firm also emits a benefit, marginal social benefit, MSB. As seen on the graph the MSC and MPC are not equal. This has to do with the fact that the firm is not burdening all of its costs on itself, namely part of its costs are burdened by society. Because of this, negative externalities occur. The gap between the MSC and MPC represents the negative externality, in this case, of production. Furthermore, the gap between MSC and MPC represents the loss of welfare, and is represented by DWL, dead weight loss. MPC intersects MSB at Q_e and C_e, this is the point where the firm is producing at its equilibrium cost and quantity. MSC intersects MSB at Q_so and C_so, this is the social optimal point, allocative efficiency. Since market failure is described as the under or over allocation of resources towards a good or service.

The government solution would be to have a corrective tax. The equilibrium quantity is greater that the socially optimal quantity therefore there is an over allocation towards production of a good or service. With a corrective tax the government increases the cost of production for the firm. This means that the supply will decrease, the equilibrium quantity will decrease to social optimal quantity. This way fewer resources will be allocated towards the production of a good. The amount of tax that has to be inflicted must be the gap between the MPC and MSC. As one can see, the tax is burden by bother consumers and producers. Since the price has increase to buy the good, the demand has decreased. Since the supply has also decreased to the socially optimal level, there is no loss of welfare because the demand has also decreased. The tax that the government receives can be used to repair the damage done by the good.

Another alternative for the government would be to directly control the polluting firm. This way firms are limited to what they are allowed to emit. This is however easier said than done. First, monitoring the emissions of a firm can be very difficult and thus costly for the government. The government has to have a way to enforce it limitation on polluting firms. Another question raised is: Can we put a price tag on environmental damage? The punishment has to have a greater incentive to not pollute than pollute otherwise firms will continue to pollute to lower their costs.