Firms that make and sell paper also create as a by product of the manufacturing process, a chemical called dioxin. Scientists believe that once dioxin enters the environment it raises the population’s risk of cancer, birth defects and other health problems.

Is the production and release of dioxin a problem for society? We examined how markets allocate scarce resources with the forces of supply and demand and we saw that the equilibrium of supply and demand is typically an efficient allocation of resources. To use Adam Smith’s famous metaphor the invisible and of the marketplace leads self interested buyers and sellers in a market to maximize the total benefits that society derives from that market. Markets are usually a good way to organize economic activity. Should we conclude therefore that the invisible hand prevents forms in the paper market from emitting too much dioxin?

Markets do many thing well, but they do not do everything well. In this article, we begin our study of another of the Ten Principles of Economics: governments can sometimes improve market outcomes. we examine why markets sometimes fail to allocate resources efficiently how government policies can potentially improve the marketer’s allocation and what kinds of policies are likely to work best.

The market failures examined in this article fall under the general category of externalities. An externality arises when a person engages in an activity that influences the well being of a bystander and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is adverse it is called a negative externality; if it is beneficial, it is called a positive externality. In the presence of externalities society’s interest in market outcome extends beyond the well being of buyers and sellers who participate in the market, it also includes the well being of bystanders who are affected indirectly. Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize the total benefit to society as a whole. The release of dioxin into the environment for instance, is a negative externality. Self interested paper firms will not consider the full, cost of the pollution they create and, therefore will emit too much pollution unless the government prevents or discourages them from doing so.

Externalities come in many varieties as do the policy responses that try to deal with the market failure. Here are some examples.

The exhaust from automobiles is a negative externality because it creates smog that other people have to breathe. As a result of this externally drivers tend to pollute too much. The federal government attempts to solve this problem by setting emission standards for cars. It also taxes gasoline to reduce the amount that people drive.

Restored historic buildings convey a positive externality because people who walk or ride by them can enjoy their beauty and the sense of history that these buildings provide. Building owners do not get the full benefit of restoration and therefore, tend to discard older buildings too quickly. Many local governments respond to this problem by regulating the destruction of historic buildings and by providing tax breaks to owners who restore them.

Barking dogs create a negative externality because neighbors are disturbed by the noise. Dog owners do not bear the full cost of the noise and, therefore tend to take too few precautions to prevent their dogs from barking. Local governments address this problem by making it illegal to disturb the peace.

Research into new technologies provides a positive externality because it creates knowledge that other people can use. Because inventors cannot capture the full benefits of their inventions, they tend to devote too few resources to research. The federal government addresses this problem partially through the patent system, which gives inventors use of their inventions for a period of time.

In each of these cases, some decision maker fails to take account of the external effects of his or her behavior. The government responds by trying to influence this behavior to protect the interests of bystanders.

Excerpts from ‘Pollution’