Market Failure: Externalities, Public Goods and Common Pool Resources

Market failure and externalities

A market fails when the free market, left alone, does not allocate resources at the point that maximises social welfare. The most common source is an externality: a cost or benefit that falls on a third party who is neither the producer nor the consumer of the good.

• Marginal private cost (MPC) — the cost actually paid by the firm.
• Marginal social cost (MSC) — the full cost to society, $\text{MSC}=\text{MPC}+\text{external cost}$.
• Marginal private benefit (MPB) — the benefit to the buyer.
• Marginal social benefit (MSB) — the full benefit to society, $\text{MSB}=\text{MPB}+\text{external benefit}$.

The free market settles where $\text{MPC}=\text{MPB}$. The socially optimal allocation is where $\text{MSC}=\text{MSB}$, which is the definition of allocative efficiency. Whenever the two points differ, the wedge between them creates a welfare loss (also called deadweight loss): a triangle whose area measures the welfare society throws away.

With a negative production externality — a cement plant polluting a river — MSC lies above MPC, the market over-produces, and the welfare loss triangle sits to the right of the optimum. With a positive consumption externality — vaccination, education — MSB lies above MPB, the market under-consumes, and the triangle sits to the left of the optimum.

Merit, demerit, public goods and common pool resources

Merit goods are under-consumed because buyers underestimate the private benefit or cannot afford it; demerit goods are over-consumed for the mirror reason. Both are usually bundled with an externality, but the two ideas are separate: the externality is about third parties, the merit argument is about the consumer misjudging their own benefit.

Public goods are non-rivalrous (my use does not reduce yours) and non-excludable (nobody can be kept out). Because of non-excludability the free rider problem appears: rational consumers wait for someone else to pay, so private supply collapses to zero even when total benefit exceeds total cost. National defence and flood barriers are the standard examples.

Common pool resources are rivalrous but non-excludable — ocean fisheries, groundwater, the atmosphere as a carbon sink. Every extra unit taken subtracts from what others can take, yet nobody can be excluded, so each user rationally over-extracts. This is the tragedy of the commons, and it is the sharpest link in the syllabus to the key concept of sustainability: the stock is drawn down faster than it regenerates, so the loss falls on future users who have no voice in today's market.

Government intervention

The toolkit: Pigouvian taxes, subsidies, regulation and legislation, tradable permits (cap-and-trade), education and awareness, direct provision, and collective self-management of a commons. Each is judged on whether it internalises the externality, whether the regulator can measure the external cost, and who ends up bearing the burden.