What happens when markets do not work perfectly?
As our survey of market structures shows. 1110St market structures fall into the broad category of imperfect competition. Because these structures do not allocate goods and services in the most efficient way, economists call them An market failures. However, imperfect competition is not the only form of economic inefficiency. Externalities and public goods are also evidence of market failure.
An externality is a side effect of production or consumption that has consequences for people other than the producer or consumer. You might think of externalities as spillover effects, either costs or benefits, resulting from the ac tions of companies or individuals.
Externalities occur in many ways and take many forms. When a factory dumps chemical waste into a river and the polluted water affects the health of people who live downstream, that is an externality. If a neighbor plants a new flower garden and the results please you, that is also an externality. If that same neighbor holds a party with loud music that keeps you up at night, that is an externality, too. In fact, it is an externality if you hear the music at all, whether you like it or not.
Now consider a more complicated example of spillover effects. Suppose that a corn syrup factory, run by a fi rm that we will call Acme Corn Syrup Company, produces an unpleasant odor, and every day that odor drifts into a nearby neighborhood. The odor is an externality by itself, but it has other side effects as well. Because of the smell, some people in the area decide to sell their homes. The odor is so bad, however, that no one wants to buy the houses, so as a result, housing prices fall.
An economist would consider the decline in property values around the factory to be a cost of corn syrup production, but it is not a cost paid by Acme Corn Syrup Company. Rather, this cost is external to the company and is borne by homeowners in the community. That external cost is an externality.
There are two types of externalities: negative and positive. A negative externality is a cost that falls on someone other than the producer or consumer. This cost may be monetary, but it may also simply be an undesired effect. Most of the examples discussed above are negative externalities.
A positive externality, on the other hand, is a benefit that falls on someone other than the producer or consumer. If you enjoy hearing the music from a neighborhood party, that spillover sound is a positive externality. Other examples include the broader benefits of getting an education or developing a less-polluting car. Students who get a college education benefit directly by getting higher-paying jobs. But if their success also results in greater economic prosperity for their communities, that is a positive externality. ln the same way, if a car company designs a new car that emits fewer pollutants, the company may benefit from increased sales. But society benefits, too, as a result of reduced air pollution.
Another type of positive externality is known as a technology spillover. The benefit from a technology spillover results when technical knowledge spreads from one company or individual to another, thereby promoting further innovations. For example, other car companies might expand on the less-polluting car design to make additional improvements in pollution control. Those improvements are a technology spillover.
Although positive and negative externalities have very different results, they are both examples of inefficiency and market failure. That is because they fail to factor all costs of production and all benefits to consumers into the model of supply and demand.
To understand what this means, consider the case of negative externalities generated by our imaginary corn syrup company. When Acme produces corn syrup, it incurs a private cost. This private cost, however, does not take into account the external cost paid by others as a result of Acme’s pollution.
If Acme were to factor in this external cost, its total cost of production would increase. To make up for this extra cost, Acme would have to increase the price of corn syrup. In response to a price increase, the quantity of corn syrup demanded would most likely decrease. Acme would then have to 10IVer its output to match the shrinking demand.
The fact that these changes in price and quantity demanded do not occur under ideal market conditions is a sign that the market is not working efficiently. The result is that goods that generate negative externalities tend to be overproduced, because their full cost is not reflected in the market price.
The reverse is true of goods and services that generate positive externalities. They tend to be underproduced relative to their benefits. Consider a beekeeper who sells honey for a living. The money she makes from her business is her private benefit. The beekeeper’s neighbors, however, receive an external benefit when her bees pollinate their flowers and fruit trees at no cost. They may wish that she would double her number of hives. But unless the beekeeper can reap a private benefit from doing so, she is unlikely to expand her business no matter how much it might benefit her neighbors.
Another example of market failure involves public goods — goods and services that are not provided by the market system because of the difficulty of getting people who use them to pay for their use. Examples of public goods include fire and police services, national defense, and public parks. Public goods are the opposite of private goods, or goods and services that are sold in markets.
Economists make two key distinctions between public and private goods. First, private goods are excludable. This means that anyone who does not pay for the good can be excluded from using it. A grocery store, for example, will sell apples only to customers willing to pay for them. Public goods, on the other hand, are nonexcludable. Think of streetlights. How could you prevent some people from using the light from streetlights? You could not, so this makes them nonexcludable.
Second, private goods are said to be rival in consumption, which means that a good cannot be consumed by more than one person at the same time. Thus, for example, if you buy an apple and eat it, that apple is no longer available for anyone else to eat. In contrast, public goods are nonrival in consumption. One person’s use of a streetlight’s glow does not diminish another’s ability to use its light as well.
Based on these two characteristics, you can see why parks and sidewalks are considered public goods. No one can be excluded from using them, and anyone can enjoy their benefits without depriving anyone else.
Private firms do not provide us with these public goods for a simple reason: they have no way to make the people who benefit from nonrival and nonexcludable goods pay for them. Economists call this situation the free-rider problem. If streetlights were a private good, for example, the company that provided them would want to charge the people who use them. But street lighting is not excludable, so anyone who passes under a streetlight can take a “free ride“ by using the light and not paying for it. Because of these free riders, no private business will provide street lighting. The result, from the point of view of economists, is a market failure.
Externalities and public goods remind us that markets do not always work perfectly. As a matter of fact, they do not work perfectly much of the time. However, this does not mean that the market system is fatally flawed. Despite its weaknesses, the market system is still the most effective, efficient, and flexible way for all of us to get the things we want and need.