Quick Summary

• Market failure occurs when market outcomes are inefficient due to imperfections and externalities.
• Externalities are impacts of individual or firm actions not reflected in market prices, leading to social costs or benefits.
• Negative externalities cause overproduction, while positive externalities lead to underproduction relative to social optimum.
• Government interventions, such as taxes, subsidies, and tradable permits, aim to internalize externalities and correct market failures.
• Private solutions, like social norms and bargaining (Coase theorem), can address externalities under specific conditions.
• Public policies must consider potential government failure due to informational issues, political incentives, and bureaucratic power.
• Property rights enable internalization of externalities by assigning exclusive control, but their extension can be complex.

Concepts and definitions

• Market failure: Inefficient market outcomes caused by imperfections and externalities.
• Externality: Uncompensated impact of one party’s activity on another; can be negative or positive.
• Negative externality: External costs, such as pollution, leading to overproduction.
• Positive externality: External benefits, such as education, leading to underproduction.
• Market equilibrium: The point where supply equals demand, which is not necessarily socially optimal in the presence of externalities.
• Internalizing externalities: Adjusting private costs or benefits to reflect social costs or benefits, often via government policy.
• Property rights: Legal rights to use and control resources, enabling bargaining to internalize externalities.
• Government failure: Inefficiencies arising when government policies are influenced by informational asymmetries, political incentives, or bureaucratic power.

Formulas, laws, principles

• Market efficiency condition: Equilibrium occurs where marginal private benefit = marginal private cost.
• Social optimum: When marginal social benefit = marginal social cost.
• Negative externality correction: Tax set equal to external cost, $ t = external_cost \ per\ unit $.
• Positive externality correction: Subsidy equal to external benefit, $ s = external_benefit \ per\ unit $.
• Pigovian taxes and tradable permits: Both aim to align private incentives with social welfare.
• Coase theorem: If transaction costs are zero, private bargaining can internalize externalities efficiently.

Methods and procedures

1. Identify externalities: Determine if external costs or benefits exist in the activity.
2. Estimate external costs/benefits: Measure social costs or benefits associated with activity levels.
3. Design policy intervention:
   • For negative externalities: implement Pigovian taxes or regulate emissions.
   • For positive externalities: provide subsidies or promote public goods.
   • Consider tradable permits for emission rights.
4. Assess private solutions: Facilitate bargaining or social norms to internalize externalities when feasible.
5. Implement regulations: Enforce emission standards or establish property rights.
6. Monitor and evaluate: Ensure policy effectiveness and adjust as needed, considering potential government failure.

Illustrative examples

• Negative externality: Aluminum production emits pollution, causing social costs higher than private costs. Addressed via pollution tax or permits.
• Positive externality: Education benefits society by increasing productivity, leading to subsidization practices achieving social optimality.
• Private solution: Charitable organizations like Greenpeace raising awareness to reduce environmental externalities voluntarily.

Pitfalls and points of attention

• Confusing private costs/benefits with social costs/benefits.
• Overlooking transaction costs and bargaining problems that limit private solutions.
• Misestimating external costs or benefits, leading to ineffective policies.
• Assuming government always improves efficiency; beware of government failure.
• Extending property rights without considering enforcement costs.
• Ignoring political incentives that can distort policy decisions.

Glossary

• Externality: Uncompensated impact on third parties from individual or firm activity.
• Market failure: Situation where market outcomes are socially suboptimal.
• Pigovian tax: Tax designed to correct negative externalities by aligning private costs with social costs.
• Tradable permits: Market-based approach allowing firms to buy/sell emission rights to meet environmental targets efficiently.
• Coase theorem: Under zero transaction costs, private bargaining can solve externality issues efficiently.
• Property rights: Legal rights enabling resource control and bargaining.
• Government failure: Inefficient outcome due to policy distortions or informational problems.