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3.3 Market Failures and the Role of Public Policy

Learning Objectives

  1. Define market failures.
  2. Discuss how government efforts to address market failures can be justified to achieve desired social outcomes, such as sustainability.

Government interventions in a private market economy are intended to correct so-called market failures or to achieve a societal objective. We focus here on government interventions to correct private market failures. Market failuresInstances in which the private market fails to allocate societal resources in the most economically efficient manner. can justify government intervention on market efficiency (economic) criteria. A key type of market failure that government tries to address in regulations and laws are externalities. Government policies are also used to address societal concerns that are associated with private market economies, such as economic inequalities. For sustainable businesses, the most relevant market failures are externalities, and we focus on these as follows.


An externality occurs when a so-called third party who is not directly involved in an economic transaction is affected by that market transaction. For example, when pollution produced by a private company negatively impacts the air quality and natural environment and harms the health of others. Externalities typically are considered in a negative context but can have either a positive or a negative impact on the third party. Government can constructively intervene when an externality in a private market transaction has a negative impact on a third party and the third party does not receive any compensation for the negative impact.

In the absence of government intervention, when externalities exist, market prices do not reflect the full costs or benefits in the production or consumption of a good. In the case of external costs, such as pollution, producers may not bear all the societal costs of production, and this would translate to lower prices to consumers than they should pay. For market efficiency purposes consumers should pay the full costs, private and social, of the products and services they consume. If an individual or business does not pay the full (private and social) costs of goods and services they consume, this would cause a good to be overproduced and overconsumed while pushing additional costs on to individuals not involved in the transaction. In the case of pollution, a company could profit by not paying the true cost of managing its waste, and others (i.e., the broader public) would be burdened by the costs—including loss of natural resources, loss of pleasure from the environment because of environmental degradation, and public health problems caused by the pollution.

Oil and oil sales and consumption can have high external costs to society beyond the price charged by the oil company. The pollution from oil use has external costs. And oil use can increase dependency on foreign resources, including on foreign countries with repressive governments.

Public policy through a tax on the use of a product or service that produces a negative externality like foreign oil can work to internalize the cost of the externality and improve the workings and efficiency of the market. Since carbon dioxide contributes to greenhouse gas emissions and global warming, and global warming has costs to society, a carbon tax on a product or service that when produced or consumed emits CO2 (such as the generation of electricity with high-sulfur coal, gasoline, or oil) can address a negative externality. It does this by putting a price on the externality and by having companies and consumers internalize the costs associated with what were unpriced externalities in the private market. This can help move private companies focused on profits to activities that better reflect their net social value, such as energy companies providing more renewable energy.

On the other hand, if there is an external benefit to a product, the producer may not be able to capture those societal benefits in the price of the product resulting in underproduction and under consumption of the good. In this case, a public policy argument might be made to subsidize the good to help increase consumer demand for the good or help improve the producer’s prospects for profitability. An example of such a subsidy would be the government assisting with the development of clean energy or a new technology that helps to reduce greenhouse gas emissions and the societal costs associated with greenhouse gas emissions. The government support could encourage greater entrepreneurial pursuit and investment in innovation and new technologies in renewable energy and energy efficiency, and society could benefit.

Failure to Assign Property Rights

Externality problems often occur in market economies when property rights are not properly assigned. Environmental problems often arise because of a lack of well-defined and enforceable property rights. Climate change is a stark example of this because nobody “owns” the atmosphere and in turn, humans have been able to add greenhouse gases to it without cost. This is now causing rising global temperatures and instability in our climate system (see Chapter 2 "The Science of Sustainability").

The challenge is to define property rights for shared resources, such as the natural environment, that are hard to exclude usage of without incurring very high transaction costs and costs to individuals. This can make environmental policy controversial, especially when you take what was a free good—such as the ability to pollute at no cost—and put a price or cost on it.

Environmental policy is often foremost about creating and enforcing property rights for environmental resources at minimum cost. In practice this means that collective or public authorities assume de facto ownership and take action to restrict previously unlimited free access to resources, such as water or air, as places to pollute. Who pays becomes an issue of critical importance and controversy. While restrictions can benefit society at large by improving water and air quality, they can come at a cost. This includes not only transaction costs for implementing, monitoring, and enforcing restricted use but also costs for those individuals and companies that had been polluting at no cost and now have a cost imposed on them or have to change their behavior and find other solutions to their waste disposal.

Key Takeaways

  • Market failures can justify government intervention.
  • Private market failures related to sustainable business that government tries to address are externalities.
  • Market failure correction efforts are the most relevant justifications for public policies that address sustainability.
  • The absence of property rights for the atmosphere and environmental resources leads to externalities and market failures. While property right assignment to a public authority can help to restrict use and overcome the absence of property rights and the market failure, it often comes with significant costs.


  1. Take the position that the most appropriate role for government is to limit business taxes and regulations. What is the strongest case for limited government? Use as a resource.
  2. Take the position that government intervention in a private market economy can be beneficial to achieve sustainability objectives. Why are governmental environmental policies and regulations justified?
  3. What is a market failure? Give an example of a market failure. How can government policy help overcome market failures?
  4. Why are property rights critical to a market economy? How do resources that are not owned by anyone get used? Do they always get used in the most economically valuable way? Does your local public park get used in a way that optimizes its long-term economic value?