For new economics students, one of the most striking parts of the subject is how it simplifies reality to build assumptions for its models. People become “economic agents” who always make rational decisions to optimize their utility (maximize their well-being) despite evidence that psychological biases or marketing campaigns can heavily influence us. Classical economists even believed the “invisible hand” of the free market would ensure market forces produced socially beneficial outcomes simply through the power of everyone acting in their own self-interest.
Skepticism of these ideas has risen over the last few decades, with evidence suggesting that these basic assumptions often fall flat. Ecological concerns are a prime example — consumers and market forces don’t consider the environment by default, which can lead to suboptimal outcomes. The concept of market failures and externalities account for this.
What is a market failure?
A market failure happens when the neoliberal dream of a free market that efficiently allocates resources fails to produce an optimal outcome.
Sometimes, the market might incentivize a person or a company to make a worse societal decision. There’s a lot that the market doesn’t account for, such as individual well-being, equality, and the environment. For instance, a company may not be incentivized to invest in an innovative new technology that would positively impact the world but wouldn’t yield significant profits.
There are many reasons for market failure. One is insufficient information, which can cause people or businesses to make incorrect decisions. Another is market structures such as monopolies, which prevent the market from being efficient due to insufficient competition.
In this article, we’ll focus on one market failure type: Externalities.
What are externalities?
Externalities encompass a production or consumption decision's external costs (or benefits). Two people or groups may be involved in a transaction, but the transaction also impacts a third party, who isn’t accounted for. This third party incurs private or social costs due to the transaction.
Externalities can lead to overproduction or underproduction of goods or services, leading to an outcome that isn’t economically efficient or socially optimal.
Vaccination is a simple example. An individual decides whether or not to have a vaccination based mostly on the costs and benefits to themselves — but their decision has a knock-on effect due to the power of herd immunity. The costs and benefits they consider when making this decision don’t “price in” the externality.
Emissions as an externality
Our article about the need for economic growth discussed the problems associated with pursuing endless economic growth due to environmental implications.
Emissions are another externality — market forces don’t require companies to account for carbon emissions when deciding how to manufacture their products or consumers to account for them when purchasing. Yet emissions can have a negative social impact in the form of:
- Lower quality of life
- Higher healthcare costs
- Lost production or consumption opportunities due to environmental destruction
This means the third party of the environment — and future generations who would benefit from a cleaner world — aren’t considered in production or consumption decisions.
It’s especially tricky since environmental resources are mostly public goods, meaning no individual or group privately owns them. As a result, nobody has an economic incentive to care for them — even though we suffer if nobody takes care of them.
How to solve the problem of externalities
Since the primary issue with externalities is that goods and services don’t account for them, some economists believe the solution is ensuring that costs reflect them. In other words, the government could intervene to make more socially undesirable transactions more “expensive” and socially desirable transactions “cheaper.”
Here are a few ways this could be achieved.
Taxes
One of the simplest ways to price in externalities is through a tax. For instance, the government can artificially increase the cost of a plane ticket to account for emissions or force companies that don’t use renewable energy in their production to pay them a tax.
This is known as a “Pigouvian tax” in Economics after the economist Arthur Pigou.
Note that the aim isn’t necessarily to achieve zero emissions, as reducing emissions isn’t the only factor to consider.
Subsidies
In the case of positive externalities, the government can go in the opposite direction and give subsidies to encourage people to move forward with a certain transaction.
For instance, the UK government has numerous solar panel grants for people who meet the criteria. This encourages people to choose renewable energy sources that are expensive but have a positive impact on society at large.
Final words
Externalities highlight where the traditional economic model falls short in accounting for a broader societal impact, and emissions are a prime example. Measures like government intervention in the form of taxes or subsidies could be a solution, but there’s no easy answer.
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