Market Failure: Externalities and Public Goods Resources
In this topic, students will be introduced to the concept of market failure and learn about its two prime examples, the presence of externalities and the provision of public goods. The concept of externalities will be explained through the use of examples such as environmental protection and technological innovation. The resources identified below also include a brief coverage of market efficiency, which would usually be covered elsewhere, if the instructor wishes to review.
- Define the concepts of market efficiency and market failure (2,3,5)
- Define externalities and explain how they constitute a market failure (3,5)
- Describe the third party problem (5)
- Discuss detailed real-world examples of positive and negative externalities (3,5,6)
- Define public goods and explain why they constitute a market failure (3,5)
- Describe the free rider problem (5)
- Define the “tragedy of the commons” and discuss possible solutions (3,5,6)
NOTE: This Module meets Ohio TAG's 2, 3, 4, 5 and 6 for an Intro to Microeconomics Course OSS004
Recommended Textbook Resources
Full Citation: Greenlaw, S. and Shapiro et al. Principles of Microeconomics 2e. OpenStax CNX. June 4, 2018. License: Principles of Microeconomics 2e by OpenStax is licensed under Creative Commons Attribution License v4.0
- Chapter 12: Environmental Protection and Negative Externalities
- Chapter 13: Positive Externalities and Public Goods
These two chapters combined cover learning objectives 2 through 6. Learning objective 1 is covered in the recommended supplemental text and learning objective 7 is covered by a video. Both are listed under Task 3: Supplemental Content/Alternative Resources.
Supplemental Content/Alternative Resources
Alternative Texbook Resource:
Full Citation: University of Minnesota Libraries, Minneapolis, MN. Principles of Economics, Publishing Ed. 2016. University of Minnesota, (CC BY-NC-SA 4.0), 2016.
- Chapter 6: Markets, Maximizers, and Efficiency: Sections 6.2 and 6.3 address market efficiency and market failure, respectively, and may provide additional insight into the subject for instructors and students. Section 6.3 also provides a more complete definition of common property resources than the primary recommended text.
- Chapter 18.2: Alternatives in Pollution Control: This section provides another description of alternative methods of pollution control. It also includes an assessment of the effectiveness of government pollution-control efforts.
The following four videos are produced by George Mason University. The selected videos are part of an extensive collection of videos that cover most topics in microeconomics.
- MR University. “An Introduction to Externalities”: This video provides a good introduction to the topic of externalities. Viewing time is 12:14 minutes.
- MR University. “Trading Pollution”: This video introduces the topic of pollution allowances (cap and trade) as a way of reducing pollution. This video is embedded in the PowerPoint slides for this topic. Viewing time is 4:08 minutes.
- MR University. “The Coase Theorem”: This video explains the Coase Theorem in reasonably clear terms. Viewing time is 8:16 minutes.
- MR University. “The Tragedy of the Commons”: This video addresses the “tragedy of the commons” which is one of the stated learning objectives for this topic that is not covered by the primary text. Viewing time is 10:35 minutes.
Active Learning Exercise
Application Exercises 1 and 2:
The two studies below are from the St. Louis Fed’s Page One Economics series.
- "How Economics Informs Environmental Policy: A Case Study of Shale Gas and Oil," David F. Perkis, Page One Economics®, March 2019
- This study examines cap and trade and pollution taxes as alternative ways to regulate pollution and concludes that the optimal method is dependent on the nature of the pollutant being regulated. The case includes eight multiple choice questions. However, instructors may assign student teams to discuss and compare the merits of cap and trade vs. taxes or to find and describe real-world examples of each.
- "Economics and the Environment," Scott A. Wolla, Page One Economics®, September 2014
- This is a concise summary of the major issues in environmental economics that could be assigned as supplemental reading for in-class or on-line discussion. Instructors may wish to ask questions such as:
- What is the relationship between property rights and externalities?
- What are the principal economic solutions to pollution?
- What are the tradeoffs involved in reducing pollution?
Application Exercise 3 - Understanding the Tragedy of the Commons
- Understanding the Tragedy of the Commons: This is an application exercise in which students will discuss the meaning of the tragedy of the commons and ideas for preventing it in the context of deforestation in Haiti. The exercise description includes tips on facilitation, possible discussion questions and suggested takeaways.
The exercise listed above is included in Starting Point: Teaching and Learning Economics
Questions and Problems
Market Failure: Externalities and Public Goods
Questions and Problems
- The Big Darby Creek is a State and National Scenic River that affords recreational opportunities to people in central Ohio. The water quality of the river and the health of wildlife that live in or by the river are being threatened by increased groundwater runoff caused in part by poorly-planned residential housing development close to its banks.
- Identify the externality in this case.
- Who are the parties to the transaction that creates the externality?
- Who are the third parties?
- What are some potential solutions to the externality?
- Referring the Figure 12.5 in the text, answer the following questions:
- Why do we prefer points P, Q, R, S and T to point M?
- How does society choose among points P, Q, R, S and T?
- How would the graph change if new technology were developed that allowed us to reduce pollution much more cheaply?
- How would the graph change if we discovered cheaper techniques for recovering fossil fuels that led to a lower cost of oil?
- Compare and contrast command-and-control solutions with market-oriented environmental tools as a way of addressing pollution. Explain why economists generally prefer market-oriented environmental tools.
- Explain why the social benefits of education may exceed the private benefits. How might the government attempt to assure that the “supply” of education is at its socially-optimal level?
- Many public school systems require that students be vaccinated against communicable diseases including measles, mumps, rubella and polio before being allowed to attend school. Make an argument in support of this requirement using the concept of externalities.
- Consider the following two statements you might hear from consumer activists or environmentalists regarding pollution. Do you agree? Why or why not?
- Forcing companies to pay pollution taxes or install costly pollution-abatement technology won’t work because they’ll just pass the tax or cost increase on to the consumer.
- Our goal should be to eliminate all pollution.
- Indicate whether the following are private goods or public goods:
- Streetlights in your neighborhood.
- A Dave’s Single with Cheese at Wendy’s.
- Your town’s annual Fourth of July fireworks show.
- Disney World
- A comedy show at a local club.
- Students sometimes face a “free rider” problem when assigned a team or group project. Describe why the problem may arise and suggest some ways to address the problem.
- Groundwater runoff is creating a social cost by flowing into and polluting the Big Darby. Those harmed by this pollution are not being compensated for that harm.
- The parties to the transaction are developers (homebuilders) and homeowners.
- Everyone who bears the cost of pollution.
- Among the potential solutions are restrictions on how close homes can be located to the Big Darby or the construction of retaining ponds to hold runoff.
- Points P, Q, R, S and T are efficient but point M is not. If the economy is at P, W, R, S or T, we couldn’t get more Output without having to give up some Environmental Protection. If we’re at point M, we could get more Output and more Environmental Protection.
- That depends on our “social preference function”. There may be other factors that affect our choice.
- The PPF would pivot at maximum Output allowing more Environmental Protection at any given level of Output.
- The PPF would pivot up at maximum Environment Protection allowing more Output at any given level of Environmental Protection.
- Command-and-control sets explicit limits on pollution or stipulates specific pollution control technologies. Market-oriented environmental tools include pollution taxes, cap and trade programs or better-defined property rights. The problems with command-and-control include the lack of incentive to reduce pollution beyond the explicit limit or to develop more efficient abatement technologies, inflexibility and a risk that standards will be subject to political whim or favoritism. Market oriented solutions give firms the incentive to develop more efficient ways to combat pollution.
- The private benefits of obtaining an education include compensated benefits like expanded job opportunities and higher earnings as well as uncompensated benefits such as personal enrichment. The social benefits of education include a citizenry that is likely to be better–informed about the issues of the day and more engaged in public discussion. As a way to encourage more education, government may require schooling up to a certain age but it can also provide subsidies to education from early childhood through college as a way to increase the demand for education and, therefore, the supply of educated citizens.
- Vaccination creates a positive externality. The private benefit of being vaccinated is that you will not contract the disease you’ve been vaccinated against. The social benefit of your being vaccinated is that you won’t spread a communicable disease to those who are not vaccinated. That category includes those who are too ill or too young to get the vaccine themselves.
- Students should recognize that the purpose of the tax or additional cost is precisely to raise the private cost of production so that it reflects the full social cost. Just how that additional cost is borne by consumer (in the form of higher price and lower quantity demanded) and producer (in the form of fewer sales and lower profits) will depend on the relative elasticities of demand and supply.
- Students should recognize that what we call pollution is a cost of production and that, other things equal, the more pollution we eliminate, the higher the opportunity cost in terms of foregone output.
- Depending on how the team project is assigned and graded, some students may have the incentive to let other team members do the bulk of the work while they share in the grade. Ways to avoid the free rider problem include peer evaluations or assigning specific parts of the project to individual team members or even requiring that individual contributions to a team report be identified by ink color or other means. Instructors may be able to minimize the incentive to free ride by emphasizing the valuable lessons in leadership and cooperation that team projects can teach.