Efficiency and market failure
Markets usually allocate resources well when buyers and sellers bear all the costs and receive all the benefits of a transaction. A market failure is a case where the market outcome is not efficient. Three common causes are externalities, public goods and market power.
Externalities
An externality is a cost or benefit that falls on someone who is not part of the transaction.
- A negative externality imposes costs on third parties, such as pollution from a factory. The social cost equals the private cost plus the external cost, so the market produces too much.
- A positive externality gives benefits to third parties, such as vaccination reducing the spread of disease or a neighbour's well-kept garden. The market produces too little.
Worked example: pollution tax
A steel firm's private marginal cost per tonne is 10 dollars. Smoke from its plant causes 3 dollars of damage to nearby residents per tonne, so the social marginal cost is 13. Left alone, the firm produces where private marginal cost matches the price, ignoring the 3.
A Pigouvian tax of 3 dollars per tonne makes the firm's cost 13, equal to the social cost. Output falls to the efficient level and the firm "pays for" the harm. The tax revenue can fund cleanup or reduce other taxes. The opposite tool for a positive externality is a subsidy equal to the external benefit.
Other solutions
- Regulation, such as a cap on emissions.
- Tradable permits: the government sets the total allowed pollution and firms trade permits, so the cuts happen where they cost least.
- Property rights and bargaining. The Coase theorem says that if bargaining costs are low and property rights are clear, the parties can negotiate an efficient outcome whoever holds the rights. This breaks down when many people are affected.
Public goods
A good is rival if one person's use reduces what is left for others, and excludable if non-payers can be kept out. A public good is non-rival and non-excludable, such as national defence or a lighthouse. Because people can free ride, enjoying the good without paying, private firms do not supply enough, so governments provide them using taxes.
Other categories: private goods (rival and excludable, such as a sandwich), club goods (excludable but non-rival, such as a streaming subscription) and common resources (rival but non-excludable, such as ocean fish). Common resources face the tragedy of the commons: overuse because each user ignores the cost to others.