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The original news article based on which this commentary is written can be found here.
This article discusses the intervention of the Indonesian government and their
implementation of several regulations regarding sustainability. Their main aim is to
encourage the consumption and production of more environmentally and economically
sustainable goods and services, and to take measures to discourage demerit goods of the sort.
Indonesia has long been neglecting not only domestic environmental issues, but also the external consequences and costs every other country would incur for collective damage to common pool resources – the atmosphere being one of them – and the climate in general. Now, economists are attempting to raise awareness of such issues and how there could be long-term negative effects on third parties as a result of not changing the priorities of the nation’s governing body. Nonetheless, there are conflicting views regarding the opportunity cost of implementing such regulations, and whether the pros, in reality, outweigh the cons.
The following diagram illustrates the effect of the imposition of a subsidy on firms producing in a high fossil-fuel emitting market.
Assume the market starts at equilibrium at the quantity of Qe1 and the price of Pe1, after which a subsidy is imposed by the government. Subsidies are granted to producers with the aim to lower the cost of fossil fuel production to consumers and to lower the production cost and encourage increased production for firms. Being a non-price determinant of supply, a subsidy creates a shift of the supply curve (by the amount of the subsidy) as opposed to a move along said curve. Pe1 lowers to Pe2, and since the law of demand states that as the price of a good or service decreases, the quantity demanded increases, ceteris paribus, as a result Qe1 will increase to Qe2. This has a significant effect on stakeholders, especially when the subsidized industry revolves around energy. Producers are now incentivized to increase production, since they can increase their income as a result. With a higher quantity demanded and a higher production ability, unemployment will likely be reduced, as employment costs will now be comparatively lower to revenue.
In the case of Indonesia’s role in global pollution, the government has exacerbated the issue by subsidizing high fossil fuel-emitting firms. This was implemented with the intention of aiding low-income households, making up 10% of the entire population. Fossil fuel-based electricity is an inexpensive option, being affordable for the poorest and more vulnerable groups in society. On the other hand, many of such subsidies are poorly targeted, disproportionately benefiting wealthier groups, since they naturally use more of the subsidized fuel. This was a result of the implementation of fossil fuel-subsidies in Indonesia, making it extremely unsustainable, and benefiting those who could get by paying at a higher price. Furthermore, subsidies come in the form of indirect and direct taxes on households, meaning that overall, higher taxes are paid, negatively impacting lower-income households in particular.
The following diagram illustrates the costs third parties (in this case, the environment) incur and negative externalities associated with unsustainable production of a good or service.
If one assumes that a firm produces quantity Qe1 of a particular good at price Pe1, and the firm emits carbon dioxide in the process, the equilibrium (and therefore the market price) is an inaccurate reflection of the external costs to society, which are higher than the single firm’s costs of production. Allocative efficiency is achieved when MSB=MSC at an equilibrium, which is where there are supposedly no externalities (at a given quantity, the externality is equal to MSC-MPC). Therefore, the market price is too low, and consumers are not paying off the expenses the society will eventually have to face.
This graph shows a welfare loss, which represents the cost to society due to loss of economic efficiency as a result of an externality, or even methods of government intervention. The economy runs at optimum efficiency when there is no welfare loss, so the aim is to reduce the negative externality, hence reducing the area of the welfare loss triangle on the above graph. The only reasonable solution for doing so is to increase the costs of production to the firms through taking away the previously imposed subsidy, as well as possibly adding a carbon emission tax for producers. In this way, emitters must pay for each ton of fossil-fuels released into the atmosphere, increasing their costs of production according to the damage they do to the atmosphere. As a result, the MPC curve would shift upwards, as producers are now paying more for the same quantity of goods. Firms will likely take action to try to avoid or minimize this tax, by adopting new and more sustainable technology, with a lower long-term societal cost.
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