Externalities: Market Failure or Political Failure?

According to Prof. Mark Pennington, externalities occur when private actors impose costs on other actors without paying appropriate compensation. Economists often use externality problems, such as pollution, to make arguments in favor of government action. However, these advocates of government action often overlook that fact that government action is itself a negative externality.

Politicians’ decisions guide government action. Politicians win elections by promising benefits to small interest groups at the expense of the masses. Most public policies in the world, therefore, do not improve upon market outcomes. Rather, these policies increase the overall costs of externalities on society by spreading costs over larger numbers of people. Put another way, the political process, and the government actions that follow, systemically externalize costs.

Markets, just like governments, are highly imperfect institutions. However, markets do provide incentives to internalize costs. Entrepreneurs and capitalists find creative ways to charge for the value that they create. For instance, broadcast television became profitable when entrepreneurs bundled television with paid advertisements. The profit motive of the market may not solve all externality problems, but it may do a better job than vote-seeking politicians.

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