Market Failure Lecture part 2: Externalities and Public Goods

Ok, so continuing the lecture on market failure, I'll turn now to discuss externalities.

Externalities aren't really a separate topic from public goods, but it's useful to focus on them to clarify the problems presented by public goods.

An externality is when a decision by an actor or actors creates benefits or costs for third parties who had no influence over that decision. Usually, that means that the price for the good that is causing the externality is either too low or too high. The market is no longer able to set the socially optimal price for the good.

When a good creates positive externalities, the price for the good will be too high relative to the socially optimal price. The classic example of a good with positive externalities is a vaccination. When someone becomes vaccinated, they not only protect themselves from infection; they also protect those around them. However, the market price for the vaccine will only reflect benefit of the individual immunization. Consequently, the price will be too high, and demand will be too low. Government can correct this problem by subsidizing the price (either on the consumer side or the producer side).

When a good creates negative externalities, the price for the good will be too low. The classic example here is air or water pollution. When a company pollutes, the good it's producing is actually imposing social costs that are not captured in the market price of the good. The price for the good will be too low and demand for the good will be too high relative to the socially optimal level. In that kind of situation, government can impose an tax (on either the producer side or the consumer side) for the good to correct the distorted price.

So, with this concept in mind, we can return to the public goods problem. We can recast these issues in terms of externalities. National defense, the prototypical public good, can also be seen as the prototypical externality problem. If Bill Gates decides to assemble a private army to defend his country from Canada, everybody in the country will benefit. His action would yield a positive externality for everyone in the country. Consequently, the market price for a private army capable of defending the country from invaders is too high, relative to the price that would optimize social welfare.