2.8 Market failure - externalities and common pool or common access resources

Socially optimum output occurs where social marginal benefit equals social marginal cost, including relevant external benefits or costs.

The market outcome can overproduce a harmful good or underproduce a beneficial one when private incentives omit spillovers.

Compare private and social marginal curves and identify the welfare-maximising quantity.

If pollution adds $2 social cost per unit, social marginal cost lies above private cost and the optimum quantity is lower.

Optimum depends on the objectives, evidence and valuation used.

An externality is a cost or benefit imposed on a third party outside the market transaction; it can cause over- or under-allocation and deadweight loss.

Negative production/consumption externalities shift social cost above private cost; positive externalities shift social benefit above private benefit.

Name source, direction and affected third party, then locate the welfare loss.

A factory’s emissions harm neighbours, so private output exceeds the socially efficient level.

Not every spillover is large enough to justify the same policy.

A common pool resource is rival but difficult to exclude users from, so individual extraction can deplete the shared stock.

Open access creates a “tragedy of the commons” when users ignore the cost imposed on others and future users.

Identify rivalry, exclusion difficulty and the governance rule that could protect the stock.

An open fishery may be overharvested because each boat gains while depletion is shared.

Common pool is not the same as a public good: rivalry matters.

Responses include taxes, subsidies, regulation, tradable permits, property rights, quotas, community governance and information.

Effectiveness depends on measurement, enforcement, monitoring, rights and stakeholder legitimacy.

Match the instrument to the mechanism and state its implementation risk.

A catch quota with monitoring can protect a fishery; without enforcement, the quota may not change behaviour.

One instrument rarely solves every externality or distributional concern.

Policy evaluation compares effectiveness, efficiency, equity, administrative feasibility, unintended effects and sustainability.

A policy can meet its target at high cost or shift harm to another group or place; outcomes should be measured against a counterfactual where possible.

State the criterion, evidence and trade-off before recommending or rejecting a policy.

A carbon tax cuts emissions but burdens low-income households unless revenue is recycled or alternatives are available.

Evaluation is not a list of pros and cons without a clear objective.