Markets can be amazing at allocating resources when the right conditions hold. But when they don’t hold, markets can go very wrong. One of the most common and important ways markets fail is through something called an “externality”.
An externality occurs when a person or a business takes an action that affects others but doesn’t fully pay the cost or receive the benefit of that action. As a result, the full consequences of everyone’s decisions will not be reflected in market outcomes, and the market will suffer from what we call a “market failure.”
A classic example is pollution. When a factory emits pollution into the air, that pollution may cause health problems, reduce property values, or contribute to climate change. But in a classic competitive market with no regulation, the factory doesn’t pay for those damages. It only pays for the cost of production, not the cost imposed on society. That’s a negative externality, and it implies the market will end up producing more pollution than is socially optimal.
Externalities are everywhere. Traffic congestion is another example. Each driver on a busy road contributes to delays for everyone else but they don’t pay a price for doing so. Or think about overfishing in a shared ocean. Each fishing boat is trying to maximize its own catch, but the more fish it takes, the fewer are left for everyone else, now and in the future.
But not all externalities are negative. Some are positive. If you get a flu shot, you’re not just protecting yourself, you’re protecting everyone around you by reducing the spread of illness. That’s a benefit to others, but it’s typically not reflected in the market price. So people underinvest in things like vaccines or education, because individuals only have incentives to think about what benefits them and not society as a whole. Depending on the size of the externality, even the most pro-social individuals may not do as much as we’d like them to do.
In both cases—positive and negative—the market gets the quantity wrong. We end up with too much of the harmful stuff and too little of the helpful stuff.
That’s where policy can come in. Economists generally favor approaches that try to align private incentives with social costs and benefits. That could mean taxes on pollution, subsidies for vaccinations, congestion pricing in cities, or cap-and-trade systems for carbon emissions.
The goal isn’t to eliminate all pollution but to push the market to the right outcome, where people and firms act as though they take into account how their actions affect others. And while taxes and subsidies often get criticized as "distorting" the market, that distortion isn’t always bad. When there’s a market failure like an externality, well-designed policy can actually move the market closer to the efficient outcome—not further from it. In cases like these, government intervention doesn’t reduce efficiency—it improves it.
Makes perfect sense, but flu shots have a ways to go before they are truly effective. I don't have a problem with other vaccines.
In the last paragraph, I think “thought” should be “though”.
Also “efficient outcome” may be a problematic term because it depends upon the objective and not all actors have the same objective; costs and benefits are usually unequally distributed. The process of setting taxes or regulations to reduce pollution or other negative externalities is an exercise in collective decision making in which compromises and tradeoffs are made. Some people will be made better off and others worse off. There will be an outcome, but whether it is considered efficient or preferred probably depends who you ask.