Unit 10 Market successes and failures: The societal effects of private decisions

10.5 External effects: More examples and diagnoses

external cost, negative externality, external diseconomy
A negative external effect: that is, a negative effect of an economic decision on other people, that is not taken into account by the decision-maker. It may be described as an external cost, or a negative externality, or an external diseconomy. See also: external effect.
external benefit, positive externality, external economy
A positive external effect: that is, a positive effect of an economic decision on other people, that is not taken into account by the decision-maker. It may be described as an external benefit, a positive externality, or an external economy. See also: external effect.
missing market
When there is no market within which a potentially beneficial exchange or trade could occur, because of asymmetric or non-verifiable information, we say that the market for the good is missing.
private property
Something is private property if the person possessing it has the right to exclude others from it, to benefit from the use of it, and to exchange it with others.
A legal document or understanding that specifies a set of actions that parties to the contract must undertake.
asymmetric information, asymmetry of information
Information that is relevant to the parties in an economic interaction, but is known by some but not by others. See also: adverse selection, moral hazard.
verifiable information
Information is verifiable if it can be verified by a court and hence used to enforce a contract.

The problem of external effects illustrated by our analysis of Weevokil arises in many different economic settings. Costs like pollution, which are inflicted on others without compensating payments, are termed external diseconomies or negative externalities, while uncompensated benefits conferred on others are external economies or positive externalities.

Negative production externalities

Chlordecone and PFOA are specific examples of a widespread problem, where firms’ production decisions have negative external effects on the environment, and hence on the wellbeing or livelihoods of the local population—or globally, in the case of carbon emissions. Two more examples are the oil spills by Royal Dutch Shell in the Niger Delta, and lead poisoning in Idaho caused by the Bunker Hill Company (Section 5.14). Other negative externalities of firms’ activities include:

  • Noise: People living near major international airports may experience intrusive levels of noise that can damage physical and mental health.
  • Inadequate safety measures: The Rana Plaza building in Dhaka, Bangladesh, collapsed in 2013, killing more than 1,100 garment workers in factories supplying apparel to global brands at low prices.
  • Deforestation for logging and commercial agriculture destroys the resources and livelihoods of local communities and causes wildfires; it has huge impacts globally on biodiversity loss and climate change.

When firms make decisions without accounting for the full social cost, one interpretation is that there are missing markets for some of the inputs, so they are treated as if their price was zero. There is no market for a quiet neighbourhood or biodiversity, so airports and loggers do not have to pay to use up these resources. In turn, the price of the product (flights, or tropical hardwood) is too low; it is based only on the inputs that are paid for. Or we might interpret the problems in terms of property rights: the garment workers did not have an enforceable right to be safe at work.

market failure
If the allocation resulting from market interactions is not Pareto efficient, we describe the situation as a market failure. The term may be used loosely to refer to any interaction resulting in a Pareto-inefficient allocation, whether or not a specific market is concerned.

To understand some of the reasons why markets fail, it is helpful to remember the institutions that are needed for them to work well. As explained in Section 1.8, private property is a key requirement for a market system. You would hesitate to pay for something unless you believed that others would acknowledge (and if necessary, protect) your right to keep it. Governments provide systems of laws and law enforcement that guarantee property rights and enforce contracts. As demonstrated in the previous section, these institutions matter for private bargaining, too.

The absence of markets and property rights can often be traced to an asymmetric information problem: information about something that matters to someone other than the decision-maker—such as how much noise is produced, or which species have been endangered—cannot be observed, or is not verifiable by a court.

Negative consumption externalities

The misallocation of resources is not limited to firms polluting the environment. Likewise, our consumption decisions have serious external effects.

Since the discovery of penicillin in 1928, the development of antibiotics has brought huge benefits to humanity. Diseases that were once fatal are now treated easily with medicines that are cheap to produce. But if we use them in the wrong dosage, or for non-bacterial conditions, or fail to complete the full course because we feel better, bacteria become resistant to them. ‘Superbugs’ emerge. The World Health Organization has recently warned that we are heading for a ‘post-antibiotic era’: ‘Unless we take significant actions to … change how we produce, prescribe and use antibiotics, the world will lose more and more of these global public health goods and the implications will be devastating.’

If antibiotics are allocated by the market, as in India where they are easily available over the counter in pharmacies, the market price does not capture the full social costs of using them. Even when prescribed by doctors they may be overused, depending on the incentives facing doctors and patients. If decisions depend only on the private benefit to an individual patient—which may be small—future patients will die from previously treatable infections.

There are many other examples:

  • When we decide how, and by how much, to heat our homes, we may not take into account the effect of burning fossil fuels on the climate.
  • Smoking affects the health of people nearby.
  • Our decisions to travel by car have multiple external effects: carbon emissions, air pollution, danger, and congestion for other road users.
  • Noisy students in the street late at night may disturb the sleep of residents. Like airports, they do not face the costs.
  • We use plastic bags and packaging without allowing for the impact of plastic waste on the health of humans and animals, particularly ocean species.

In most cases, we are responding to market prices that are well below social marginal costs. The information conveyed by the low price of fuel, for example, does not include the environmental costs of driving to work rather than taking the train.


We can understand why such problems are common by thinking about how they could be avoided.

How could the cost of driving to work accurately reflect all of the costs incurred by anyone, not just the private costs made by the decision-maker? The most obvious way would be to require the driver to pay everyone adversely affected an amount exactly equal to the damage inflicted. This is of course impossible to do, but illustrates what would be needed for the ‘price of driving to work’ to send the correct message.

Although the diagnoses in the examples above are similar, the efficacy of potential treatments differs—depending on the number of people affected, how easy it is to measure the effects, and the practicalities of ensuring compliance.

If the numbers of people involved are small, then—as Coase argued—a legal framework establishing the initial allocation of property rights may facilitate a mutually acceptable outcome. But transaction costs—particularly the difficulty of observing and measuring relevant information—often mean that this is not a practical solution.

Laws and legal institutions can make people face the costs of their decisions by holding them legally liable for costs they inflict on others, compensating those who are harmed. Liability law ensures that if a firm sells a car with a design fault and someone is injured as a result, the firm must pay for the damage. The law may place a duty of care on employers towards their employees, and impose fines or other penalties for an unsafe working environment.

Likewise, if you drive recklessly on the way to work, skid off the road, and crash into somebody’s house, tort law (the law of damages) in most countries would require you to pay for the damage to the house. Knowing this, you might think twice about driving to work (or at least slow down a bit when you are late). It will change your behaviour and the allocation of resources.

But while tort law can cover some kinds of harm, other important external effects of driving your car, including traffic congestion and air pollution, would not be covered.

Why don’t countries just rewrite their laws to make decision-makers pay for all the costs they inflict on others? A part of the answer is that those inflicting the harm on others typically are profiting from doing so, and if they are powerful enough, like a multinational company, they will be able to prevent the passage of legislation that would address the problem.

non-verifiable information, unverifiable information
Information is verifiable if it can be verified by a court and hence used to enforce a contract.
incomplete contract
A contract that does not specify, in a way that can be enforced by a court, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

Moreover, in seeking to address these problems, governments lack the necessary information (as in the case of DuPont and PFOA). Necessary information is either unavailable or unverifiable by a court. When external effects are complex or difficult to measure, contracts are incomplete and property rights cannot be guaranteed. Think about the difficulty of enforcing a contract between neighbours limiting noise levels, or writing a complete set of contracts giving each fisherman appropriate compensation from each plantation using Weevokil.

Economic instruments: Regulation, tradable permits, taxation

When the legal system alone cannot address a problem, policymakers look for workable forms of intervention. Direct regulation is one approach: chlordecone was simply banned, and governments set limits on the permitted levels of other harmful substances—such as lead in petrol or paint. Local governments regulate the hours during which entertainment venues are allowed to exceed a prescribed noise level.

Similarly, a government might limit the amount of effluent per month that a firm is allowed to discharge into a river. But regulation can be a blunt instrument. In the case of river pollution, it is really the total amount of effluent that matters for water quality, rather than the amount discharged by each firm. Some countries have tried to manage lakes or river systems by issuing permits that give the owner a right to discharge a certain amount of a pollutant, and allowing the permits to be traded between firms. New South Wales, in Australia, issues tradable permits for industrial discharge of salty water into the Hunter River, in order to protect agriculture and ecosystems from the effects of salinity. For this approach to work, the market price of a permit must be high enough to reflect the external cost.

In principle, tradable permits can improve the outcome, because the water authority can control the total amount of pollution, and firms that value the right to pollute highly can buy permits from firms that can more easily find other ways of operating. The permit price provides an incentive for firms to adopt less polluting technologies. In effect, this policy treatment creates a new market in response to the diagnosis that one was missing. It is not an easy solution, however: extensive monitoring is required, both to determine the appropriate pollution limits and to ensure that individual firms do not exceed their own permits.

Where the price of a good is too low to reflect the social cost, a tax may be used to raise the price and hence ensure that buyers take the social cost into account. In some countries and states, a tax on single-use plastic bags has been notably successful in changing consumer behaviour. Australia, New Zealand, and the UK have a landfill tax, which raises the fees for businesses and local government to send waste to landfill sites to reflect its environmental cost, providing incentives for waste reduction, and recycling.

External benefits cause misallocation too

Some decisions have positive external effects: the social benefit is higher than the private benefit (or the private cost is higher than the social cost).

  • If Kim, the farmer in Section 4.6, contributes to the cost of an irrigation project, all the other farmers in the community will benefit.
  • When a firm invests in R&D, the benefits can often be exploited by other firms who can adopt the new production methods or improve their own products in the same way.
  • If a firm trains a worker who later quits for a better job, the skills of the trained worker go with them: the new firm obtains at least some of the benefits of the training.
  • When someone is vaccinated against an infectious disease, they receive a benefit for themselves, but also benefit people who might otherwise have caught the disease from them.
  • If an employee exerts a high level of effort, the net private benefit (job satisfaction, for example) may be small, but the employer benefits from higher productivity.
  • A country that invests in reducing carbon emissions lowers the risks of climate change for other countries.

Why are external benefits a problem? Although they are indeed beneficial if they are conferred, misallocation of resources happens because decision-makers choose not to confer an uncompensated benefit. Kim would not receive payment for a public-spirited contribution to the irrigation project; the firm that paid for the training cannot collect compensation from the new employer. Just as people who don’t face the true costs of production or consumption decisions are likely to produce or consume too much, those whose actions have external benefits will do too little. The equilibrium of the irrigation game is that each farmer chooses not to contribute, unless they are motivated by social preferences or social norms. Likewise, firms may train too few workers, or do too little R&D, relative to the social good.

Just as for negative externalities, it is typically infeasible to use the legal system to compensate people for the beneficial effects they have on others. For example, to pay the owner of a beautiful garden for the pleasure this confers on passers-by, a court would have to know how much it was worth to each one.

Establishing property rights can address some problems: for example, a system of patents gives firms the right to exploit the results of their own R&D for a period of time. The law of copyright enables authors to receive an income from their writing, by giving them a right to determine how and where it is published. But by creating a monopoly in the use of the copyrighted material (as intended), copyrights, patents, and other intellectual property rights limit competition, which is also necessary for efficient market outcomes.

external benefit, positive externality, external economy
A positive external effect: that is, a positive effect of an economic decision on other people, that is not taken into account by the decision-maker. It may be described as an external benefit, a positive externality, or an external economy. See also: external effect.

In other cases, economic instruments can help. The Pigouvian remedy would be a subsidy to ensure that the decision-maker takes the external benefit into account. Subsidies or tax incentives can encourage firms to provide worker training; in some countries, these have been financed using a levy scheme, so that the firms that choose not to train have to pay for the training provided by others. But such systems are much more difficult to implement than a plastic bag tax, because of the need to ensure that the training provided is of a type and quality that will benefit other firms as well as the provider.

The table in Figure 10.6 summarizes the features of some of the problems we have discussed so far. In later sections, we will use the same framework for other cases of market failure.

The external effect: how it affects others Costs and benefits Misallocation of resources (market failure) Possible remedies
(full or partial)
Terms applied in this situation
A firm uses a pesticide that runs off into waterways Downstream pollution Private benefit
External cost
Overuse of pesticide; overproduction of the crop for which it is used Taxes, quotas, bans, tradable permits, bargaining, common ownership of all affected assets Negative external effect, environmental spillover
You travel to work by car Congestion, danger, and air pollution for other road users Private benefit
External cost
Overuse of cars Tolls, quotas, subsidized public transport Negative external effect, environmental spillover
A firm trains a worker Future employers benefit from the skills Private cost
External benefit
Too little work-based training Subsidies, training levy schemes Positive external effect, positive spillover

Figure 10.6 External effects and misallocation of resources.

marginal private benefit, MPB
The benefit for a producer or consumer of producing or consuming an additional unit of a good. It is called the marginal private benefit, or MPB, to emphasise that it doesn’t include any external benefits conferred on others. See also: marginal external benefit, marginal social benefit.
marginal social benefit, MSB
The marginal social benefit (MSB) is the benefit of the production or consumption of an additional unit of a good, including both the benefit for the producer or consumer (marginal private benefit) and the benefits conferred on others. MSB = MPB + MEB.

Exercise 10.5 Remedies for a positive externality

Imagine a beekeeper, who produces honey and sells it at a constant price per kilogram.

  1. Draw a diagram with the quantity of honey on the horizontal axis, so that the marginal cost of honey production is shown as an upward-sloping line, and the price of honey is shown as a horizontal line. Show the amount of honey that the profit-maximizing beekeeper will produce.
  2. For the beekeeper, the marginal private benefit of producing a kilogram of honey is equal to the price. But since the bees benefit a neighbouring farmer, by helping to pollinate their crops, honey production has a positive external effect. Draw a line on your diagram to represent the marginal social benefit of honey production. Show the quantity of honey that would be Pareto efficient. How does it compare with the quantity chosen by the beekeeper?
  3. Explain how the farmer and beekeeper could both be made better off through bargaining. Why might they be unable to bargain successfully to achieve a Pareto-efficient outcome in practice?
  4. Use the diagram you drew to show how the government might improve the situation by subsidizing honey production. Describe the distributional effects of this subsidy, and compare it to the Pareto-efficient bargaining outcome.

Exercise 10.6 Incomplete contracts

Choose three of the following examples discussed in this section: noise pollution, inadequate safety measures, deforestation, antibiotic resistance, worker training, and climate change. For each example chosen, answer the following questions:

  1. Explain why the external effects are not (and possibly cannot be) covered by a complete contract.
  2. What critical piece(s) of information required for a complete contract are asymmetric or non-verifiable?

Exercise 10.7 Property rights and contracts in Madagascar

Marcel Fafchamps and Bart Minten studied grain markets in Madagascar in 1997, where the legal institutions for enforcing property rights and contracts were weak.1 Despite this, they found that theft and breach of contract were rare. The grain traders avoided theft by keeping their stocks very low and, if necessary, sleeping in the grain stores. They refrained from employing additional workers for fear of employee-related theft. When transporting their goods, they paid protection money and travelled in convoy. Most transactions took a simple ‘cash and carry’ form. Trust was established through repeated interaction with the same traders.

  1. Do these findings suggest that strong legal institutions are not necessary for markets to work?
  2. Consider some market transactions in which you have been involved. Could these markets work in the absence of a legal framework, and how would they be different if they did?
  3. Suggest some examples in which repeated interaction helps to facilitate market transactions.
  4. Why might repeated interaction be important even when a legal framework is present?
  1. Marcel Fafchamps and Bart Minten. 1999. ‘Relationships and Traders in Madagascar’. Journal of Development Studies 35 (6) (August): pp. 1–35.