Market Failures and Externalities

Market Failure

Where the market fails to correctly allocate resources, causing a deadweight loss.

Negative externality

A harmful side effect of producing or consuming a good upon a third party.

Positive externality

A beneficial side effect of production or consumption upon a third party.

Marginal social cost

The total cost to society of producing one more good. MSC = MPC + MEC

Marginal social benefit

The total benefit to society of consuming one more good. MSB = MPB + MEB

Pigouvian tax

Per unit tax equal to to MEC of a negative externality, adding cost for the producer to MSC

Coase theorem

Proposition that if private parties can bargain without cost over allocation, they can fix externalities by themselves.

Excludibity

People can only use a good if they have paid for it.

Rivalry

One person’s consumption of a good diminishes another’s consumption.

Private goods

Both excludable and rivalrous

Public goods

Non-excludable and non-rivalrous

Common good

Non-excludable but rivalrous.

Club/Collective goods

Excludable but non-rivalrous

The free rider problem

Market failures occur when private markets under-supply public goods due to people using them for free.