Market Failure: Externalities & Common Pool Resources

Market Failure

A situation where the free market fails to allocate resources efficiently, leading to a welfare loss for society.

Externality

A cost or benefit that falls on a third party not involved in the economic transaction — not reflected in market prices.

Negative Externality of Production

When the production of a good imposes costs on third parties (e.g., factory pollution harming nearby residents).

Negative Externality of Consumption

When the consumption of a good imposes costs on third parties (e.g., passive smoking, noise pollution).

Positive Externality of Production

When production creates benefits for third parties (e.g., a beekeeper whose bees pollinate neighbouring farms).

Positive Externality of Consumption

When consumption creates benefits for third parties (e.g., vaccination reducing disease spread, education raising productivity).

Marginal Private Cost (MPC)

The cost to the producer of producing one additional unit — reflected in the supply curve.

Marginal Social Cost (MSC)

The total cost to society of producing one additional unit: MSC = MPC + Marginal External Cost.

Marginal Private Benefit (MPB)

The benefit to the consumer of consuming one additional unit — reflected in the demand curve.

Marginal Social Benefit (MSB)

The total benefit to society of consuming one additional unit: MSB = MPB + Marginal External Benefit.

Common Pool Resource

A resource that is non-excludable (cannot prevent access) but rival (one person's use reduces availability for others). E.g., fisheries, groundwater.

Tragedy of the Commons

The tendency for common pool resources to be overexploited because individual incentives lead to collective overuse.

Pigouvian Tax

A tax equal to the marginal external cost, designed to internalise a negative externality and restore the socially optimal output.

Tradeable Permits

Government-issued permits allowing a fixed amount of pollution. Firms can buy and sell permits, creating a market for pollution rights.