When there are large numbers of buyers and sellers, all with full information, exchanging similar (if not identical) goods, markets can be efficient. There are circumstances that interfere with the efficiency of these markets and when these circumstances occur, there is a market failure.

In the last two chapters, we examined the effect of market failure resulting from not having enough sellers. It was then seen how the government and the market serve to remedy this failure. In this chapter, our examination will continue into the causes of market failure by studying externalities, public goods, imperfect information, and governmental failure.

Externalities and Environmental Economics

An externality exists when the actions or decisions of one person or group impost a cost or bestow a benefit on second or third parties. Externalities are sometimes called spillovers or neighborhood effects. Inefficient decisions result when decision makers fail to consider social costs and benefits.

The study of externalities is a major concern of environmental economics. As societies become more urbanized, externalities become more important when we live closer together, our actions are more likely to affect others.

REALITY CHECK: A good example of an externality is cigarette smoke. When a person smokes a cigarette, the smoke affects others. We call this “second hand smoke” and it is a good example of how one person’s consumption can “spillover” to affect someone else.

• Marginal Social Cost and Marginal-Cost Pricing
• Private Choices and External Effects
• Internalizing Externalities