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A market failure is a situation in which the market fails to achieve an efficient allocation. A few such cases we have already seen. Both monopolies and oligopolies are, for instance, examples of market failures. Our consumption of goods does not occur in a social vacuum. Much of our consumption, perhaps all of it, indirectly affects other people. The most classical example is pollution. It does not have to be a big factory; it could be your neighbors having a barbecue party. You do not participate, but you still get a share of the smell. You might take your car to work; you pay for the fuel but not for the pollution or the congestion to which you expose others. Other examples include the use of penicillin (you are cured, but contribute to making bacteria penicillin resistant), vaccinations, and a well kept garden that your neighbors also enjoy looking at.


An externality is a situation in which the consumption or the production of goods has positive or negative effects on other people’s utility where these effects are not reflected in the price.
It is common to distinguish between positive and negative externalities:

  • Positive externalities. One person’s consumption of a good also increases other people’s utility without them having to pay for it.
  • Negative externalities. One person’s consumption of a good decreases other people’s utility without them receiving any compensation.

Note that positive externalities are also a problem. Typically, we get too few goods with positive externalities and too many goods with negative externalities.

The Effect of a Negative Externality

Let us study the classical example of a negative externality: A firm produces a good, but in doing so they also pollute the environment. First, we need to define a few concepts:

  • The marginal cost of the externality, ME. The change in the cost of the marginal effect, when production is increased by one unit. This is similar to the concept of MC, but instead of concerning the cost for the firm, it concerns the uncompensated) cost of the externality.
  • Social cost. The sum of the cost of producing the good and the cost of the external effect.
  • Marginal social cost, MSC. The sum of the firm’s marginal cost and the marginal cost of the externality, i.e. MC + ME.

Look at Figure 19.1. The firm operates in a perfectly competitive market, so MR = p. To maximize its profit, the firm chooses to produce the quantity where MC = MR, i.e. the quantity qC. However, this firm also emits pollution. The pollution does not cost the firm anything, but there is a cost to society. The more the firm produces, the more it pollutes. In the figure, we have drawn the marginal cost of the external effect, ME, and the marginal social cost, MSC = MC + ME. We see that for society, the optimal quantity to produce is qS. The effect of the firm being able to ignore the cost of polluting is that it produces too much of the good. As an indirect effect of that, there will also be more pollution than at the optimum.

Regulations of Markets with Externalities

One way to correct the situation is to put a tax on each unit of the product. If one knows the size of ME then the tax should be that same amount. Thereby, the marginal cost curve of the firm will coincide with MSC,and the firm will automatically correct its production to the optimal quantity, qS. An obvious problem with this solution is that one rarely knows ME.
Other strategies to regulate the market include quantity regulations and the creation of transferable emissions permits.

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