Externalities or spillovers are more common examples of market failure that may warrant the government intervention. Externalities are effects on third parities that are not transmitted through the price system and that arise as an incidental by-product of another person's or firm's activity. They may be positive effects on others, such as education; or negative such as pollution.
Sending a child to school benefits the child and his parents, but others also benefit somewhat if the child becomes a more informed voter and a more reliable taxpayer. The private market can capture only the money the parent is willing to pay for child's education. The numerous external beneficiaries cannot be charged. As a result, without government subsidies, the market is likely to provide less education than the community as a whole wants and is willing to pay for.
Negative externalities represent the cost side of other actions. Pollution, for example, hurts the community at large, but if the costs do not appear on the firm's profit-and-loss statement, they are usually ignored. The community then gets more pollution-causing production than it desires. A tax on effluents can internalise the external cost and help us produce a lower, more satisfactory level of pollution.
Externalities are everywhere. Polio shots, newly painted houses, and newly planted flowers benefit many people besides those directly involved. Crabgrass, loud radios, and costly vehicles all impose incidental costs on others. And honking horns, flashy/ties, and mini-skirts produce external benefits for some and costs for other. The externalities concept is both terribly useful and terribly troublesome. What should be noted here is that it could be used to justify an extremely pervasive government role in the economy. Most economists do not think externalities should justify such a role. The concept of government failure helps to indicate why.
A simple example of an externality and failure of state is the occurrence of the pollution of sub-soil water in Kasur district in the decades of eighties and nineties. Pollution was caused by tanneries, using chemicals to wash and tan leather, and consequent failure of the public authorities to lay down rules and procedures for the appropriate disposal of toxic waste resulting in seepage of chemicals into sub-soil water, thus causing the pollution to the extent that the water was no more drinkable.
Spillover of such externalities brings adverse effect on the concept of equality (both horizontal and vertical), and in many cases transfer the state authority of taxing people to non-state actors. Resultantly, the state cedes its authority to non-state elements, and gradually their demand or extortion of money shapes into a regular pool money. That is a form of state failure.
The spread of externalities, if allowed to continue, brings violence, civil war, organised crimes, extinction of civic amenities, etc. Just observe, market around Regal Chowk in Karachi, one does not find footpaths, cleanliness for a healthy environment. These places have been occupied by immigrants or by criminal elements with the support of local government and police. These elements are exploiting the weaknesses of the local government. A place worth million of rupees is being utilised by these elements who pay a very meagre amount in the shape of bribe to those who are responsible to protect and safeguard public rights. In this manner, the state is being robbed and society is being cheated.
We daily listen, obviously in business news, talks and seminars that economic health of society is not improving because there is a painfully low tax-to-GDP ratio. We are not collecting sizable taxes to meet the government expenditure. That is true, but who is responsible - the state itself, long rule of authoritarian regimes led to the erosion of state authority. It is interesting to note that an ordinary citizen is contributing a lot more tax, both to the state and non-state elements, without getting benefits. The basic cause of these problems is the existence of negative economic externalities and that is the failure of state to regulate different spheres of life. Regulations per se are not bad, as they safeguard individual's rights, but improper application or non-existence of such regulations leads to market failure, thereby causing inequality, unemployment, crimes and violence.
I propose that if we have to grow as a modern state, we will have to look into these areas and to review and enforce regulations to safeguard individual's rights. Take the case of collection of advance income tax. Usually, such deductions are restricted to organised businesses and organisations. According to our laws, this duty has been placed on a much larger segment of society and it will lead to exploitation as our checks through audits are very weak.
We have experienced emergence of misuse of rebate payments, sales tax refunds, tax exemptions and instruments, creating special rights and privileges. And in this way, the state failed to safeguard the equity principles as a few people gained at the cost of common man. All this has led to the emergence of a wealthy class, and this class is failing to abide by its duties and obligations because the state has failed to protect equality and equity considerations and the gap between the haves and have-nots is increasing day by day.
The reasoning in the preceding discussion is typically used to support the conclusion that markets will fail to achieve allocative efficiency when there are externalities. Another conclusion that is sometimes drawn from that same analysis is that externalities require and justify the government intervention in allocation decisions if efficiency is sought. Although, external costs and benefits may arise in a variety of ways, focus on air and water pollution is a specific example of external costs. The analysis of other externalities would be equally essential.
It will be helpful if we think of pollution control or, more generally, the reduction of external costs as an activity. Pollution control can be achieved by reducing the scale of the pollution-generating activity. Pollution control may also occur as production and consumption process are altered. For example, scrubbers and filters may lessen air pollution emitted by a steel mill. The value of such pollution control activity is the reduction in the pollution damages that it brings about. As the degree of control increases, the total damages form pollution decrease, but the total costs of controlling pollution increase. So society may choose to bear fewer pollution costs (damages) by bearing more pollution control costs, but it cannot escape both costs.
In the light of what I have stated above, I'll submit that unless these economic externalities are not controlled, the state will continue to heavily rely on borrowing, thereby striking inflation and making a common man's life more miserable. And the state by limiting its capacity to enforce taxation measures and to control non-state elements will be pushing society towards chaos.
(The writer is a graduate of University of Southern California and an Advocate and is currently working as Managing Partner of M/s Azim ud Din Law Associates Karachi.)