Market Failure, Externalities, and Public Policy
Core concepts
Markets fail when they produce inefficient outcomes. Externalities are spillover costs or benefits to third parties. A negative externality (pollution) means marginal social cost exceeds marginal private cost, so the market overproduces; a positive externality (education) means marginal social benefit exceeds marginal private benefit, so the market underproduces. Remedies include Pigouvian taxes on negative externalities, subsidies for positive ones, tradable permits, and Coasean bargaining when property rights are clear and transaction costs low. Public goods are nonrival and nonexcludable, causing free-rider problems and underprovision. Common resources are rival but nonexcludable, risking overuse (tragedy of the commons). Asymmetric information produces adverse selection and moral hazard. Monopoly power also creates deadweight loss. Government failure - imperfect information, rent-seeking, unintended incentives - can worsen outcomes.
Traps to watch
- Reversing the over/underproduction direction for each externality type.
- Calling a good public merely because government provides it.
- Assuming taxes always improve efficiency; they can create their own deadweight loss.
- Confusing adverse selection (hidden type before the transaction) with moral hazard (changed behavior after).
Worked example
A factory's marginal private cost is $20 but marginal social cost is $30. A Pigouvian tax of $10 per unit aligns private and social cost, reducing output toward the efficient level. Rule of thumb: tax equal to the marginal external cost.