5.5 Market Failures, Public Goods and Externalities

Notes

A market failure occurs when a market on its own does not use resources efficiently.

• Public goods are nonexcludable (people cannot be kept from using them) and nonrival (one person's use does not reduce another's). Examples: national defense, streetlights, lighthouses.
• The free-rider problem: people can benefit without paying, so private firms will not supply enough public goods. Governments usually provide them with tax money.
• An externality is a cost or benefit that falls on people outside a transaction.
• Negative externality: a factory's pollution harms neighbors. The market produces too much of the good because the polluter does not pay the full cost.
• Positive externality: vaccines and education benefit others too. The market produces too little.
• Possible responses: taxes or regulations for negative externalities; subsidies for positive externalities. Economists debate which tools work best in each case.
• Other market failures include imperfect information (one side knows much more than the other) and lack of competition.