Since the inception of the aviation industry, it has had an amazing expansion with passenger growth still at 14% as recent as 2010 [The Economist, 2011]. For the years the aviation industry has been running, each flight causes a negative externality – a root cause of market failure. To solve this problem of market failure, governments have intervened by introducing a number of regulations over the year, to protect the welfare of society. However, the externality the aviation industry causes cannot be solved so simply. Pollution of CO2 and NOx gasses are the negative externalities caused by each flight, and with daily flights the damage is forever raising. To overcome this market failure in the aviation industry, the European Union Trading Scheme will be introduced from 2012. The government will intervene by placing a cap on the amount of gasses firms are allowed to release through their flights. The theory of the plan suggests that emissions will reduce over time and will push airlines to find alternative resources. What’s The Problem?
Market failure is the term that economists use to describe situations where one person incurs costs or enjoys the benefits of another's action [Shiell, A, 2010]. There are four main reasons as to why market failure occurs: Monopoly power, Public goods (see Appendix A), Asymmetric information (see Appendix B) and Externalities. Within the airline industry, the latter comes into play. Market failure caused by externalities occurs when a party that is not involved in the decision making (third party) is affected as a result of that decision. There is a negative spill over effect and this causes markets to become inefficient and therefore fail. Externalities are effects of production or consumption on third parties where the price does not cover the full social cost. They are classed as positive (see Appendix C) or negative (see Appendix D) [Helbling, T, 2010].
It is deemed that the externalities of the airline industry have more adverse effects in the form of pollution, which may lead to a decreased quality of life. This problem has been further emphasized in the wake of the constant concerns of global warming in the media. There is also the issue of other externalities such as noise pollution (see Appendix E), congestion (see Appendix E), and the forgone production in terms of a polluted area (where an airport is located) is likely to affect activities such as tourism. Negative externality caused by market failure occurs due to the market not taking into consideration the complete social cost of an action. As firms are profit maximising entities as described by neo classical economics, they will produce a greater quantity of products compared to what is socially desirable. Taking an example of the aviation industry, the social costs of the airliner carrying out more flights is an increase in pollution and the release of other toxic gasses.
As seen by the diagram, the social optimal output level is where the demand curve intersects with the social cost curve. But this is not the case as the current equilibrium is below the optimum one, as private firms only take into account private costs, creating inefficiency and hence market failure.
Graph Adopted from: Harcourt Brace & Company. (2011). Externalities, Chapter 10. p16. There are a number of policies that can be put into the place in order to combat market failure. They may be private such as negation and compensation, or they may be implemented by government. Through direct or indirect measures such as command and control policies or market based policies such as Pigouvian taxes. (Appendix F).
The government had meticulously assessed the aviation market and concluded that there was a...