The government needs to get involved and internalize the profit and cost externalities. Production, consumption, and investment choices of people, families, and companies usually influence individuals not directly engaged in the business transactions. At times, such indirect effects have negligible impacts. Nevertheless, when their influence is significant, they may be problematic and are referred to as externalities. The occurrence of externalities is the major reason behind government intervention in the monetary sphere. Cost externalities result in markets exchanging larger quantities of output than what is socially suitable (Bernardo, Schwartz, & Welch, 2015). The government assists in the eradication of inefficiencies emanating from cost externalities through taxing products.
A real-life illustration of why government intervention is vital is pollution, the traditional instance of a negative externality (Aznar-Márquez & Ruiz-Tamarit, 2016). The production of most goods leads to pollution by companies. Nonetheless, devoid of intervention by the government, the outlay of pollution is not considered in the cost of the items, and its effects are felt by everybody, even those people who have no part to play in the market. When the government intervenes, it charges the negative externalities through regulations or application of market-anchored strategies, for instance, taxes (Benigno, Chen, Otrok, Rebucci, & Young, 2016).
If the government does not intervene, polluters make decisions anchored just in the direct expenses of and profit opportunity from manufacturing without considering the indirect outlays to the people affected by the pollution. Indirect outlays encompass poor quality of life, for instance, a homeowner residing close to a smokestack, increased medical costs, disregarded production opportunities, and the impact of pollution on practices such as tourism. Attributable to the indirect outlays not being incurred by the polluter, they are not passed on to the consumer, which makes the total or social costs of production greater when compared to private costs.
In occurrences of disparities between social and private costs or returns, the arising problem is that the market operations might become inefficient. To enhance the welfare of the members of the community, social returns ought to be exploited and the costs lessened (McGuire & Lynch, 2017).
This signifies that all expenses and benefits ought to be internalized by the companies and consumers making the manufacturing and purchase decisions respectively. If this does not happen, market operations result in the underproduction of services or commodities that involve positive externalities and overproduction when it comes to negative externalities. Underproduction and overproduction result in below-maximum market outcomes concerning the community’s general situation (what is referred to as welfare viewpoint by economists).
Social costs rise with the rate of pollution, which increases alongside the extent of production. This results in the overproduction of commodities with negative externalities when just private costs are mulled over in decisions and not expenses incurred by others.
It has been established that inadequacies linked to technical externalities result in market failure (Nguyen, Laratte, Guillaume, & Hua, 2016). Private market-anchored judgment making fails to create efficient outcomes from a general wellbeing point of view. In this aspect, governments should tax polluters a fee that corresponds to the degree of the harm caused (Pang, 2017). Such taxation would create a prevailing market outcome that has sufficient internalization of all outlays by polluters.
The government needs to get engaged and internalize the profit and cost externalities. Through its intervention, the government assists in the suppression of inefficiencies emanating from cost externalities via taxation. A good example of why government intervention is fundamental is pollution.
References
Aznar-Márquez, J., & Ruiz-Tamarit, J. R. (2016). Environmental pollution, sustained growth, and sufficient conditions for sustainable development. Economic Modelling, 54, 439-449.
Benigno, G., Chen, H., Otrok, C., Rebucci, A., & Young, E. R. (2016). Optimal capital controls and real exchange rate policies: A pecuniary externality perspective. Journal of Monetary Economics, 84, 147-165.
Bernardo, A. E., Schwartz, A., & Welch, I. (2015). Contracting externalities and mandatory menus in the US corporate bankruptcy code. The Journal of Law, Economics, and Organization, 32(2), 395-432.
McGuire, C. J., & Lynch, D. (2017). The need for environmental justice never ends because externalities persist. Environmental Justice, 10(3), 68-71.
Nguyen, T. L. T., Laratte, B., Guillaume, B., & Hua, A. (2016). Quantifying environmental externalities with a view to internalizing them in the price of products, using different monetization models. Resources, Conservation and Recycling, 109, 13-23.
Pang, Y. (2017). Profitable pollution abatement? A worker productivity perspective. Resource and Energy Economics, 52, 33-49.