Learning Objectives

  • Define externalities and market failure
  • Explain how markets do not always allocate goods efficiently, due to externalities

Markets offer an efficient way to put buyers and sellers together to determine the quantity of goods which will be produced, the price that will be charged. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. But the efficiency of markets depends on the assumption that only the buyer and seller are affected by the transaction. What happens when a voluntary exchange affects a third party who is neither the buyer nor the seller?

When a market does not operate efficiently, the result is called market failure. Markets usually work best when there are no unintended side effects, but that’s not always the case. Sometimes people share in the benefits of others’ production or consumption. For example, when you get the flu shot, your neighbors benefit also by not getting the disease from you. They benefit from a side affect of your consumption. Or, you can be negatively impacted by the decisions of others. If your neighbor doesn’t mow their lawn or maintain their home, that hurts the value of your home. In this situation, laissez faire is not the best policy.

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watch It

Watch this video to see how externalities and public goods are examples of market failure.

Consider an example of a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighborhood. You will be able to hear these outdoor concerts while sitting on your back porch—or perhaps even in your dining room. In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction. The effect of a market exchange on a third party who is outside or “external” to the exchange is called an externality. Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spillovers.

Externalities can be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality. If you love country music, then what amounts to a series of free concerts would be a positive externality.


The rapid growth of technology has increased our ability to access and process data, to navigate through a busy city, and to communicate with friends on the other side of the globe. The research and development efforts of citizens, scientists, firms, universities, and governments have truly revolutionized the modern economy. To get a sense of how far we have come in a short period of time, let’s compare one of humankind’s greatest achievements to the smartphone most of us have in our coat pocket.

In 1977 the United States launched Voyager I, a spacecraft originally intended to reach Jupiter and Saturn, to send back photographs and other cosmic measurements. Voyager I, however, kept going, and going—past Jupiter and Saturn—right out of our solar system. At the time of its launch, Voyager had some of the most sophisticated computing processing power NASA could engineer (8,000 instructions per second), but today, we Earthlings use handheld devices that can process 14 billion instructions per second.

Still, the technology of today is a spillover product of the incredible feats NASA accomplished forty years ago. NASA research, for instance, is responsible for the kidney dialysis and mammogram machines that we use today. Research in new technologies not only produces private benefits to the investing firm, or in this case to NASA, but it also creates benefits for the broader society. In this way, new knowledge often becomes what economists refer to as a public good. This leads us to the topic of this chapter—technology, positive externalities, public goods, and the role of government in encouraging innovation and the social benefits that it provides.

Positive Externalities in Public Health Programs

One of the most remarkable changes in the standard of living in the last several centuries is that people are living longer. Thousands of years ago, human life expectancy is believed to have been in the range of 20 to 30 years. By 1900, average life expectancy in the United States was 47 years. By the start of the twenty-first century, U.S. life expectancy was 77 years. Most of the gains in life expectancy in the history of the human race happened in the twentieth century.

The rise in life expectancy seems to stem from three primary factors. First, systems for providing clean water and disposing of human waste helped to prevent the transmission of many diseases. Second, changes in public behavior have advanced health. Early in the twentieth century, for example, people learned the importance of boiling bottles before using them for food storage and baby’s milk, washing their hands, and protecting food from flies. More recent behavioral changes include reducing the number of people who smoke tobacco and precautions to limit sexually transmitted diseases. Third, medicine has played a large role. Immunizations for diphtheria, cholera, pertussis, tuberculosis, tetanus, and yellow fever were developed between 1890 and 1930. Penicillin, discovered in 1941, led to a series of other antibiotic drugs for bringing infectious diseases under control. In recent decades, drugs that reduce the risks of high blood pressure have had a dramatic effect in extending lives.

These advances in public health have all been closely linked to positive externalities and public goods. Public health officials taught hygienic practices to mothers in the early 1900s and encouraged less smoking in the late 1900s. Many public sanitation systems and storm sewers were funded by government because they have the key traits of public goods. In the twentieth century, many medical discoveries came out of government or university-funded research. Patents and intellectual property rights provided an additional incentive for private inventors. The reason for requiring immunizations, phrased in economic terms, is that it prevents spillovers of illness to others—as well as helping the person immunized.

Watch It

Watch this video to examine the costs and benefits of both positive and negative externalities. We’ll examine how these externalities affect the market and influence the graph of supply and demand in more detail soon.

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a market exchange that affects a third party who is outside or “external” to the exchange; sometimes called a “spillover”
market failure:
when the market on its own does not allocate resources efficiently in a way that balances social costs and benefits; externalities are one example of a market failure
negative externality:
a situation where a third party, outside the transaction, suffers from a market transaction by others
positive externality:
a situation where a third party, outside the transaction, benefits from a market transaction by others
see externality