Externalities

The market generally assures that when benefits are enjoyed, they are enjoyed by the individual who incurs the expenses to provide them. However, there are circumstances when individuals or firms do not bear all of the costs for the benefits they enjoy. When someone other than the recipient of a benefit bears the costs for its production, the costs of the benefit are external to its enjoyment. Economists call these external costs negative “externalities.” Externalities amount to a market failure to distribute costs and benefits efficiently.

An example of an externality is a poultry farm that raises and sells chickens, thereby earning a profit (benefit). While raising the chickens, however, the farm releases a significant amount of pollution into the river that runs by the farm. The people who live downstream from the farm bear an external cost (polluted water) of the farm’s operations. Similarly, when a motorist enters the freeway, he or she adds to the congestion, danger, and pollution already there. Some of the costs of the motorist’s activities are born by other drivers on the road. These costs can become significant when numerous drivers enter the freeway at the same time (rush hour). Because individuals and firms are not bearing the full costs of their actions while enjoying the full benefits thereof, the incentive is to persist in the externality-producing behavior.

When negative externalities arise, the government often seeks to remedy the resulting imbalance in costs and benefits by regulating or penalizing the behavior that produces the externality. (Such actions are frequently responses to complaints by those who bear the costs of the externalities.) These efforts by government minimize the occurrence of negative externalities and facilitate a more efficient distribution of benefits and costs.

Not all externalities are negative, however. In some cases, all of the benefits of an activity are not captured by the individual or firm who pays for them. For example, if a family remodels their home and cleans up their yard, the value of their home increases, but so do the homes of their neighbors. The family that remodeled is the sole bearer of the costs of remodeling and cleaning up, but other homeowners in the area receive some of the benefits in the form of a positive externality. In general, positive externality-producing activities will be underprovided by individuals in an unregulated market. In such cases where the positive externalities produce a collective public good, the government may be justified in promoting such behavior through financial or other incentives. An example of a positive externality-producing behavior the government currently encourages with tax benefits is adoption; parents who adopt enjoy the benefits of bringing a child into their home, and the rest of society enjoys the external benefits of having that child in an environment where he or she is likely to become a positive contributor to society.

Incomplete Markets

As noted above, some goods and services may not be “pure” public goods, but are nonetheless undersupplied by the market. There are numerous goods and services that have the potential to improve the economic fortunes of individuals and of society that are not widely available. In such circumstances, the need or demand for a particular good or service is higher than the available supply of that good or service; hence, there is an incomplete market.

Traditionally, the market has tended to undersupply insurance for particular kinds of activities or risk (especially health insurance). The market, on its own, also undersupplies loans for education and small business ventures. In each of these cases, there are government programs to complete or supplement the naturally incomplete markets that exist. Medicaid and Medicare are government financed “insurance” programs for the poor and the elderly. The Department of Education and state and local student loan agencies underwrite or guarantee loans to students attending accredited colleges and universities. The Small Business Administration helps individuals secure the funding they need to start their own businesses.