Externalities: Market Failure or Political Failure?

Mark Pennington,

Release Date
February 17, 2012


Basic Economics

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.

  • Externalities [Article]: Bryan Caplan explains the fundamentals of positive and negative externalities and examines various applications of the theory.
  • Market Failure (Video): Milton Friedman explains some of the shortcomings of conventional market failure analysis and provides an example of a private solution to a public goods problem.
  • The Ultimate Externality [Article]: Donald J. Boudreaux finds that government is often a much larger source of negative externality on net than the market.
  • Don Boudreaux on Public Choice [Podcast]: Russ Roberts talks with Don Boudreaux about the differences between political competition and economic competition.
  • Public Choice: Politics Without Romance [Article]: James M. Buchanan looks back at the origins and development of the public choice paradigm.

Externalities: Market Failure or Political Failure?
Economists often talk about externalities as a reason why government should regulate markets. Externalities refer to situations where in our private actions we may impose costs on other actors without paying appropriate compensation. So for example, when a factory pumps out noxious fumes into the atmosphere it’s imposing an externality on the people in the neighborhood who are breathing in those fumes on an involuntary basis. People often claim that externalities are exclusively the result of market failures. But before we rush to the conclusion that governments can correct for these market failures, it’s important that we recognize that most of what government does reflects the desire of politicians to win elections by promising benefits to some groups that will be paid for by others.
Most of the public policies that we see in the world are not the result of governments trying to deal with market failures, but they reflect politicians trying to externalize costs. So when governments subsidize inefficient farmers, when they subsidize inefficient energy companies, when they subsidize road-building schemes, when they prop up failing banks, and prop up failing auto companies, they are taking money from some people and giving it to others on an involuntary basis.
Markets are highly imperfect institutions and there will always be market failures. But markets do provide at least some incentives for actors to try to internalize costs. Think of the typical caricatures that many people have of capitalists. Capitalists are often described as the people who, if they could, would find ways of charging people for things that they’d previously been receiving for free. If the thing that we’ve previously been receiving for free is the ability to pollute the atmosphere then these are precisely the type of people that we want to make us pay for our polluting ways.
The profit motive in the market system may not provide the solution to all externality problems, but they may just provide more of a solution than the activities of vote-seeking politicians.