10.4: Market Failure- Externalities

This lesson is the second in the topic of market failure. The last lesson dealt with market failure caused by market power. Market power is caused by a reduction in competition. It is the reduction in competition that leads to inefficient outcomes.

For this lesson we will examine market failure caused by a breakdown in communication. In this example, miscommunication causes a misallocation of resources, and this leads to excessive environmental damage (i.e., too much pollution). After examining the root causes of market failure, we will show how economists assess costs and benefits in an attempt to find a solution to such a problem.

Communication

The economist, Adam Smith, back in 1776, wrote a book on how the free-market system allocates output and resources called The Wealth of Nations. In his book, Smith coined the phrase the “invisible hand.” According to Smith, the free market has such an uncanny ability to allocation resource that it seemed the market participants were guided by an invisible hand. The invisible was simply a characterization of the way markets work.

The Private Market

Let’s look at a simplified picture of the private market (i.e., a market without a government participant) and see how the market participants interact.

Figure 7

Figure 7 illustrates the interaction between two market participants: households and firms (we will discuss the government later). Members of households need money (i.e., income) to buy the goods and services that keep them safe (e.g., shelter), healthy (e.g., food, medicine), and happy (e.g., movies, video games, vacations). They earn this income by offering their labor to the highest bidder in the labor market.

For example, when you go to work you are selling your labor in the labor market and as a result income flows into your household (section A). This flow of income is provided to you by firms that buy your labor and use it as an input in the production process (section B). Firms receive their flow of income by going to the product market and selling to households the finished goods and services that household members helped them produce (section C). And finally, household members use their income that they earned in the labor market to buy goods and services in the product market (section D).

In the United States there are over 280 million consumers and about 20 million firms participating in the market place every day! With all these market participants producing, selling, and buying millions of different goods and services in many different markets, how does anything get done?

Communication is the Key

Our complex market system works as well as it does due, in part, to the fact that all of the participants are able to effectively communicate with each other. They communicate with each other with prices. The price mechanism allows buyers and sellers to state all of their requirements in the private marketplace so that little time and resources are wasted telling each other what they want.

How are messages sent? Here are two examples of consumer-to-firm communication.

• A seller that finds she is alone in a store daily with shelves filled with unsold merchandise is being sent a clear message by her customers; your prices are too high!
• A seller that finds herself on the sales floor, thrown there by customers surging past to get to the last unit in the store, is being sent a message: your prices are too low.

Prices act as signals to induce firms to produce the things we value most at the lowest cost – the right prices ensure that the economy maximizes the total welfare (i.e., general well-being) of its participants.

When the price mechanism malfunctions, the private market participants cannot effectively communicate. And when communication breaks down, the private market breaks down.