Externalities and Public Goods

Externalities and Public Goods:

Market Failure and Resource Allocation:

1) Market Performance:

3 big objectives in economy:

  • Efficient resource allocation
  • Equality in (re)distribution of income and wealth
  • Stability and growth of economy

Market Economy with many socioeconomic problems. Why?

Sometimes self-correcting (laissez-faire) mechanism doesn’t work well historically (The Great Depression in 1930s). Market economy does not necessarily guarantee the equivalent distribution of income and wealth. Invisible hands work in allotment through price mechanism. Through the severe competition, few people are able to survive this game to finally command the exclusive ownership of the resources and income.

Market Failure:

  • Distortion of resource allocation mechanism in the market economy due to several reasons.

Several reasons for the failure

Imperfect Competition:

Decentralized resource allocation is efficient through perfect competition. Imperfect competition through technical reasons – increasing returns to scale and natural monopoly.

Public Goods:

Non Rivalry: When consumption of a food by one person does not reduce the quantity that can be consumed by others.
Non Excludability: A good once produced is accessible to all consumers


The consequence that an action of any decision maker has on the well-being (utility) of other consumers or producers, beyond the effects transmitted by changes in prices.

Positive Externalities: Education, Bandwagon effect, health care, R&D, public transit and so on.

Negative Externalities: noise, pollution, toxic emissions, congestion, etc.


Uncertainty cannot guarantee the Pareto optimality in general equilibrium analysis. Kenneth Arrow offered that the efficient allocation can be achieved even under uncertainty if and only if there is a condition of perfect contingency market which means that there is a perfect insurance for any possible situations. But, we know this is almost impossible.

Role of the Government:

Market failure is not a sufficient condition but can be a necessary condition. Government failure? Surplus burden or Deadweight loss.

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