Market Failure: Externalities and Public Goods
External costs and benefits can be omitted from private decisions, leading competitive markets to produce too much or too little. Public goods are nonrival and nonexcludable, so voluntary funding can fall short. Taxes, donations and other arrangements can help fund them.
What a learner can do afterwards
- Compare private cost with social cost for a polluting factory and show why the market quantity is too high
- Choose a tool for a stated failure (a tax, a subsidy, a tradable permit, a rule) and justify the choice
- Explain free riding and why street lighting is not sold lamp by lamp
1 · Read
An unregulated competitive factory pays its production costs but leaves pollution damage unpaid. Social cost adds outside harm to private cost. Ignoring it leads to output above the socially efficient level. Unlike a single-price monopoly restricting output, this failure can mean excess output. A pollution charge brings harm into decisions; uncovered polluters still ignore it. Enforced permits cap emissions. Firms with cheaper cleanup sell unused permits to firms with costlier cleanup, directing cuts toward lower costs. For equally harmful units, limiting emissions also limits harm. Rules can restrict damaging activities.
Illustration: £4 private cost plus £3 outside harm gives £7 social cost per unit.
Street lighting is nonrival: one person using its light leaves it available to others. It is nonexcludable: excluding passing nonpayers is impractical. These features make it a public good. Sellers cannot readily charge every beneficiary, so voluntary payments may fund too little. Taxes can fund lighting collectively. Donations or other arrangements can also work; public goods do not always require tax funding.
A free rider enjoys a shared benefit without contributing to its cost. A family skips a patrol collection because the patrol passes its street anyway. If too many people do this, funds may fall short. For example, a patrol needs £90 but receives £60, leaving £30 unfunded. Cooperation, donations or compulsory payments can address the gap.
A beekeeper may benefit an orchard through unpaid pollination. This positive externality is a benefit outside the beekeeper's own return. If this benefit is ignored and no agreement pays for it, beekeeping may be below the socially efficient level. A subsidy tied to that benefit can encourage provision. Private agreements can help too. Support must be assessed against its costs; a spillover does not justify any subsidy amount.
Count outside costs and benefits. Match a policy to the incentive or funding gap it needs to address.
More to read
Introduction to Environmental Protection and Negative Externalities
A negative externality is an uncompensated cost imposed on people outside a decision. For a polluting factory, social cost includes private production costs and outside damage. In the competitive model, ignoring damage can make output exceed the socially efficient level. A pollution charge can price that harm. An enforced permit system caps emissions and lets firms trade allowances, directing cleanup toward lower costs. The cap is on emissions, not automatically on damage: location and the type of pollutant can matter. Rules can also restrict harmful activities. The best policy depends on the harm, monitoring and enforcement.
13.3 Public Goods
A public good is nonrival and nonexcludable. Nonrival means one person's use does not reduce what is available to others. Nonexcludable means preventing nonpayers from benefiting is impractical or too costly. Street lighting illustrates both features. Voluntary payment may fund too little because people can benefit without contributing. Tax funding is one response, but donations and other arrangements can also provide public goods. A positive externality does not automatically make a good public: a privately sold service can benefit people outside the sale.
What is a free rider?
A free rider receives a shared benefit without contributing to its cost. A family may skip paying for a neighbourhood patrol because it will pass their street anyway. If many families rely on others to pay, funding can fall short even when the service is valued. This is a risk rather than a certainty. Cooperation, appeals for donations or compulsory contributions can address it. The example concerns a deliberate choice to rely on others, not every possible reason someone cannot pay.
Public goods: real-world examples
Public goods and positive externalities overlap but are not identical. Street lighting can be nonrival and nonexcludable. A beekeeper, by contrast, sells private products while bees may also pollinate an orchard without payment. That outside benefit is a positive externality. If private agreements do not reward it, provision can fall below the socially efficient level. A subsidy or public support can help, but the size and cost of the intervention matter.
Explore more
2 · Watch
به انگلیسیTake it off screen
Where it sits
Optional connections
This opens up
Where this leads
8 questions wait behind this lesson, each with its answer explained. Every answer feeds the sky: stars light as they are learned, and dim when it is time to come back.