Externalities

Market systems work most efficiently when the prices at which goods and services are exchanged accurately incorporate information about social preferences, in which case, the price in question is called the efficiency price or scarcity price. When a price deviates from the efficiency price, it is an arbitrary price, and the transaction in question either imposes costs or confers benefits that are not reflected in the actual market price. These costs and benefits are called externalities.

Pollution is a prime example of a negative externality. When a factory discharges pollutants into water or air, it imposes costs on those affected by the pollutants. If those costs are not counted in the factory's costs of production, as has often occurred in the absence of government regulation, then the factory sells at arbitrary rather than efficient prices, and market efficiency is undermined.

Positive externalities occur when people benefit from the actions of others without paying for that benefit. For example, if I maintain the exterior of my house in impeccable condition, my actions confer an aesthetic benefit on my neighbors and other passers-by as well as a monetary benefit to any of my neighbors who choose to sell his or her house. If I can neither charge a fee to those who enjoy the consequences of my actions nor exclude them from that enjoyment, then the benefit I confer on them is called a public good.

Public goods are at the heart of the free rider problem. In general, if people can enjoy benefits without paying the costs of those benefits, they will do so. Lighthouses are a classic example. Because it was often impossible to exclude ship owners who refused to pay for lighthouse services from enjoying the benefits of those services, fewer than the socially optimal number of lighthouses were built and manned. In general, if a good or service possesses the characteristics of a public good—if at least some people can obtain access to the good without paying for it—then the actual price received by the provider of the good will be lower than the efficiency price, and the good is likely to be undersupplied by the market.

Externalities are imperfections in a market system and thus constitute one kind of market failure. When such failures occur, it is often possible for governments to correct them, for example by taxing polluters and other producers of negative externalities and by subsidizing those who provide public goods. These [Page 306]actions, if calibrated accurately, can bring prices into line with total social costs and benefits, thereby enhancing the efficiency of markets.

It is important to note that externalities constitute only one kind of market failure. Most notably, even if it were possible to devise a perfectly efficient market system, such a system still would fail to supply even the most basic needs of some people because markets supply goods only to those who have something to offer for exchange in the market. This defect can be made good only by some kind of nonmarket corrective.