When an activity creates an externality, competitive markets will allocate resources inefficiently. The level of the activity tends to be too high if the externality is negative and too low if it's positive. Markets fail because prices diverge from marginal social costs or benefits.
If the production of a good creates negative externalities, monopoly can be either more or less efficient than competition, and the monopolist's output can be either inefficiently high or low, depending on the size of the externality.
Remedies for externalities: the private sector
If bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements between private parties will remedy the market failures associated with externalities and restore economic efficiency. The assignment of property rights affects the distribution of economic benefits.
Private parties can achieve efficient solutions for externalities either through contracts or through common ownership.
Externalities result from missing markets. Negotiations can substitute for those markets.
Negotiations can fail to address an externality if bargaining is impractical, the assignment of property rights is ambiguous, different parties have limited information about each others' costs and benefits, or contracts are difficult to enforce.
Remedies for externalties: the public sector
Governments can remedy some externalities through policies that help the private sector create the necessary markets, or by creating and operating those markets.
Another remedy for externalities is to regulate the level of the activities that produce them. This strategy requires a great deal of information concerning private costs and benefits.
Another remedy for externalities is to correct private incentives through taxes, fees, subsidies, or liability rules.
Ideal quantity controls and ideal corrective taxes have different distributional implications, but are equally efficient and require similar information.
When external harms have multiple causes, well intentioned efforts to correct private incentives can go awry, leading to inefficiency.
If the government errs when setting quantity controls and corrective taxes, those two approaches need not be equally efficient.
If the external costs of pollution depend on the total emissions of many parties, an emissions tax leads to efficient abatement, while quantity controls generally do not.
As a practical matter, either a quantity standard or a tax can be more flexible, and therefore more desirable.
A system of tradable emissions permits allows the government to set overall quantity standards without sacrificing efficient abatement.
Common property resources
People tend to overuse common property resources due to the presence of negative externalities.
Possible remedies for common property resource problems include transferring the resource to an owner, limiting access, and charging user fees.
Public goods
Goods differ in their degrees of rivalry and excludability.
To determine the efficient level of a public good, we sum all parties' marginal benefit curves vertically and then find the intersection of the resulting marginal social benefit curve with the marginal cost curve.
Providing public goods creates positive externalities. The private sector underprovides public goods due to the free rider problem.
Possible remedies for public goods problems include public provision, contributions to nonprofit providers, and subsidies for private contributions.
Subsidization offers fewer advantages than in other contexts involving positive externalities because the level of the public good must be the same for everyone. Efficient subsidization may also be impractical.
The efficient provision of a public good need not entail public production.
There are procedures for setting the level of a public good that provide people with incentives to report their preferences correctly, and that produce socially efficient outcomes.
To determine whether public intervention is justified, we must weigh the consequences of market failure against the likely consequence of government failure arising from the self-interested actions of government officials.
Assuming that the public sector is constrained by majority opinion and that voters have single-peaked preferences, majority rule leads to the selection of the median ideal policy. That policy is Pareto efficient among the available policies but need not maximize net social benefits (in which case it is not Pareto efficient within a broader class of policies).
The principle of majority rule has clear implications only in simple settings. Often there is no clear majority winner, and the outcome depends on the specific rules and procedures used to make public decisions.
