Basic Economics

Market Failures and Externalities

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".


In previous analysis, we assumed that all goods consumed or produced have been private, in the sense that one individuals consumption or production of a good does not affect the other. When our actions impact on those not directly involved, an externality exists. As one individual's behaviour increases or decreases, another's satisfaction or profit changes as well. It can have a positive or negative effect on a third-party not directly involved with the buyer or seller of the transaction. These costs (or benefits) are not included in the cost curve faced by the decision makers.

Examples of externalities:

  • A smoker annoys others with second hand smoke.
  • A gardener delights a neighbour with his beautiful garden.
  • A pulp mill pollutes the air and water in town.
  • A perfume wearer gives a friend an allergic reaction.

Negative Externalities

When economic agents not directly involved, negative externalities can exist, such as pollution. A free market tends to over-produce the good which produces a negative externality, and under produce those with positive externality. If we include costs borne by everyone, then we get social costs, which are the total costs of production no matter who bears them. We say that the total cost is equal to private costs plus external costs.

Negative externalities result in a lower free-market output. In order to make the market produce the optimal amount, we must impose a tax. This is called "internalizing the externality", and forces those involved to account for external costs. There are also externalities in "consumption", when consumption has costs for persons other than those actually consuming the product. Examples of these are cigarettes and second-hand smoke, and drinking alcohol and car accidents.

Positive Externalities

Not all externalities are negative. Some create benefits to those not directly involved. Such is the case with "technology spillover", where new inventions benefit those beyond the inventors.

Some have argued that governments should subsidize research and development, since it will have positive externalities to everyone else. Another method is to allow patents to give monopoly rights to new inventions for a period of time, and encourage such activity. Without this method, there could be an under investment in research. Positive externalities in production means that social cost is less than private cost, and more of the good should be produced than will occur in a free market.

There may also be positive externalities in consumption, such as education. In this case, the social value is greater than the private value

Solution to Externalities

Externalities lead to an inefficient quantity of production and consumption. This can be remedied by either private arrangements or public policy. Externalities can be dealt with by:

  1. Moral codes and social sanctions
  2. Voluntary organizations - charitable groups, lobby groups
  3. Internalization - when activities with complementary externalities are merged into one firm, thus eliminating the externality
  4. Contracts - parties through negotiation can agree as to how to regulate the externality

Coase Theorem

If parties can bargain without cost over the allocation of resources, then the private market can always solve the problem of externalities. It can allocate resources efficiently, irrespective of how the law assigns responsibility for damages. Earlier before Coase, it was argued that the source of the externality should be penalized. It is now recognized that the party that can deal with the externality at least cost should do exactly that.