35 – Thinking like an economist 11: Externalities and market failure

“Market failure” is defined as a situation where people acting independently and individually will not result in the greatest possible benefits for society, at least if the aim is to maximise the overall benefits rather than to redistribute them. Economists usually see market failure as being necessary for government action to be justified. For example, we want to see evidence of market failure before we would sanction the use of a regulation or an economic incentive to try to change people’s behaviour in a particular situation. Without market failure, the argument goes, government action can only make things worse, because a free market would result in the best possible set of outcomes.

The idea is an important one as it provides a safeguard against wasting public money by forcing each issue to be looked at from an overall perspective, not just from a narrow sectional perspective. Without the discipline provided by rules like this, the wasteful use of public funds would be that much greater.

One of the potential causes of market failure is an externality. An externality occurs when an activity undertaken by an individual has side-effects on others that are not taken into consideration by the first individual. There are two types of externality: negative and positive (also called external costs and external benefits).

For example, suppose pollution is generated as a side effect of an economic activity. In a free market, a negative externality such as this pollution is a potential problem because the level of the activity chosen by the polluters may be too great from a social point of view (in the sense that there exists the potential to improve the welfare of both the polluter and the sufferer). If the external costs could be factored into the polluters’ business decisions, the polluting activity would probably be undertaken at a lower level. In the absence of regulation or some form of government imposed incentive, the group of polluters generates more pollution than is socially desirable because they do not consider the costs it imposes on others.

A positive externality is also a potential problem, but this time because the level of the activity is too low. For example, if planting trees on a farm has a side effect of lowering salinity on neighbouring farms, the level of tree planting may be lower than would be optimal overall.

Economists’ classic prescription for externalities is to “internalise” them; that is, to create a market in the externality so that price incentives can operate, or to use taxes or incentive payments to cause the instigator of the costs or benefits to factor them into their own decision making. Government responses to externality problems may also include direct regulation, negotiation, and use of peer pressure.

Economists have become so used to linking externalities to market failure that they sometimes speak as if the two are synonymous: as if the only really worthwhile cause of market failure is an externality, and as if any externality you observe necessarily is a cause of market failure. Both views are in error.

The first of these errors is just silly, as there are a number of other possible causes of market failure (e.g. information failure, monopoly, public goods) so it is surprising how often one comes across it.

The second of the errors (that any externality is a cause of market failure) is just sloppy economics, but it is one I have confronted frequently in my discussions with other economists.

In fact, as Alan Randall has pointed out, externalities are not an economic problem at all unless they also have non-rival or non-price-excludable characteristics. For example, an individual who over-exploits a non-price-excludable resource causes a negative externality to others through excessive depletion of the resource stocks, but it is the non-price excludability that allows the problem to occur.

Even if there are public-good characteristics to an externality, it still doesn’t follow that there must be market failure. For example, if pollution is occurring, it does not follow that each individual polluter should be forced to cut back. It is reasonably likely that some polluters are polluting more than can be justified (i.e. the costs to them of cutting back would be less than the costs to others if they do not do so). But you have to look at the two sets of costs for each individual polluter to see whether they are in the market failure category or not. In the case of dryland salinity, for example, we have found that many are not – that for many farmers, the costs of cutting back their off-site salinity impacts are high, and that the benefits to others of doing so are low.

The error is reflected in the calls by some (including by some economists) for all farmers to be forced by regulation to limit off-site salinity impacts. Given the current technologies available to farmers, such a regulation would actually be a net cost to society, in the sense that the resulting costs would exceed the benefits. If applied as a blanket measure, it would result in an overall benefit for some farms, but a large overall cost for a lot more.

So don’t jump to the conclusion that externalities are synonymous with market failure. You need to consider (a) whether they have public-good characteristics and (b) whether taking the actions needed to manage the externality would result in positive net benefits.

David Pannell, The University of Western Australia

Further reading

Pannell, D.J. (2004). Thinking like an economist 5: Public goods and public benefits in NRM, Pannell Discussions No. 22, 18 October 2004,

Randall, A. (1981). Resource Economics, An Economic Approach to Natural Resource and Environmental Policy, Wiley, New York. (There is also a 2nd edition from 1987, but I prefer the original).