Element 3.3: Avoid Inefficiencies and Waste

“What we want is to establish the rules of a market economy, not to plan its outcome.”

As we discussed in Element 2-1, if markets are going to allocate resources efficiently, property rights must be well established and producers must be able to capture the benefits of their productive actions. But the nature of some goods makes this difficult. In this element, two categories of economic activity that pose serious challenges to the efficient allocation of resources through markets are considered. They are public goods and externalities.

Public Goods

Let’s revisit in more detail the idea of goods and services where it is difficult for producers to benefit from their production. This is the case with a category of goods that economists call. These have two characteristics: (1) jointness in consumption—that is, as we discussed with national defense, (1) providing the product to one party simultaneously makes it available to others; and (2) it must be nonexcludable—that is, it is difficult to exclude nonpaying customers. For example, like national defense, flood control meets the first criterion. Once flood-control devices, like dams or reservoirs are built, everyone in the region benefits. Flood control also meets the second criterion. The supplier of flood control will have trouble charging people for the service, because if it is provided for one, it is provided to all. Thus, it is difficult to provide public goods through markets, because potential providers are unable to establish a one-to-one relationship between payment for and receipt of the good.

Consumers will have an incentive to become “free riders”—that is, to consume the good without helping to pay for it. When a large number of people become free riders, the good may not be produced (or too little of it may be produced), even when the value derived from its consumption exceeds the cost. In such cases, markets will often fail to produce a quantity of public goods consistent with economic efficiency. Flood control, national defense, municipal police protection, and mosquito abatement are examples of public goods. Because these goods are difficult to supply through markets and cover costs, they are often provided by governments.

It is important to note that it is the characteristic of a good, not the sector in which it is produced, that determines whether it qualifies as a public good. There is a tendency to think that if a good is provided by the government, then it is a public good. This is not always the case. Many of the goods provided by governments clearly do not have the characteristics of public goods. Medical services, education, mail delivery, trash collection, and electricity come to mind. Although these goods are often supplied by governments, nonpaying customers could be easily excluded, and providing them to one party does not make them available to others. Thus, even if they are provided by governments, they are not public goods. We have called these publicly-provided goods.

Most goods and services are private rather than public goods. In the case of private goods, the link between payment and receipt of the good or service can be easily established. Therefore, most products are supplied through markets. Think about this and its importance. Those individuals who pay for an ice cream, an entertainment system, a smart device, a pair of jeans, or a house enjoy these items and literally thousands of others. Those who do not pay in the marketplace do not enjoy or consume them. As we keep saying, producers in the marketplace continue to supply the products because the price voluntarily paid by you and other consumers covers the costs; those unwilling to pay the price are excluded from consumption. In the case of private goods, government provision is highly unlikely to improve on the efficiency of the market.

Externalities

Sometimes the actions of an individual or group will “spill over” and exert an impact on others, affecting their well-being without their consent. Such spillover effects are, as you already know, called externalities. For example, if you are trying to study and others in your home or apartment complex are distracting you with loud music, they are imposing an externality on you. You are an external party—not directly involved in the transaction, activity, or exchange—but you have been affected by it, detrimentally in this case.

The spillover effects may either impose a cost or create a benefit for external parties. When the spillover effects are harmful, they are called external costs. Because costs are imposed on nonconsenting parties, resources are being used to produce goods that are valued less than their full production costs. Economic inefficiency results.

Consider the production of paper. The firms in the market purchase trees, labor, and other resources to first produce pulp and then paper. The manufacturing process using old technologies emits pollutants into the atmosphere. These pollutants impose costs on residents living near the mills—a sulfuric smell, heavy smog, and breathing issues or other health hazards.

If the residents living near a pulp mill can prove harm and measure it, they could take the mill to court and force the paper producer to cover the cost of their damages. In fact, to prevent that from happening, nineteenth-century paper companies routinely bought up miles of downstream property to let river water dilute the company’s effluent.⁽⁸¹⁾ Often people found proving harm and holding specific pulp mills responsible has proved difficult and costly. When this is the case, the total costs of the pollution and other external costs will not be reflected through markets. The cost of producing paper will be understated. Inefficiency occurs because units of paper will be produced that are valued less than the costs of their production when external costs are included.

To a large degree, external costs reflect a lack of fully defined and enforced property rights. Because the property right to a resource—clean air, for example—is poorly enforced, the firm does not pay the full cost of using the resource. Thus, the cost of producing goods and services using such resources is understated.

For example, during the last decades of the 20^th century Europe and North America suffered from a large environmental threats - acid rain crisis. Acid rain resulted from emissions of sulfur dioxide and nitrogen oxides from industrial processes, power plants, and transportation. The pollutants responsible for acid rain were often released into the atmosphere by factories and power plants in one country but because of prevailing winds caused environmental damage, including deforestation and the acidification of lakes and rivers, in neighboring countries. This situation illustrates how the lack of fully defined and enforced property rights concerning air quality allowed industries to avoid accounting for the costs of pollution.⁽⁸²⁾

On the other hand, sometimes spillover effects generate benefits for others. When the spillover effects enhance others’ welfare, they are called external benefits. But external benefits can pose problems for markets, too. When the persons or firms that generate the external benefits are uncompensated, they may fail to produce some units even when they are valued more than their production costs.

For example, suppose a pharmaceutical company develops a vaccine providing protection against a deadly virus. The vaccine can easily be marketed to consumers who will benefit directly from it. They will also incur costs, even if only the pain and discomfort of the injection. Each individual will compare these private costs and benefits to decide whether or not to get the vaccine. Because of the communal nature of viruses, however, as more and more people get the vaccine, even those who have not will also be less likely to catch the virus. Yet it will be very difficult for the pharmaceutical companies to capture the benefits derived by the nonusers. As a result, they may produce too little of the vaccine to provide full immunity for the community. Thus, when external benefits are present, market forces may supply less than the amount consistent with economic efficiency.

Perhaps government action can improve the situation. In the case of external costs such as pollution, the government could tax or fine the activities that generate the pollution, which might lead the person or firm to abate its harmful activities and achieve an output level more consistent with economic efficiency. Similarly, in the case of external benefits, such as the provided by vaccines, government subsidies might spur production, resulting in a more efficient output level.

The potential consequences of externalities can sometimes be controlled without government, however. Let’s consider external benefits. Entrepreneurs have an incentive to figure out ways to capture more fully the gains their actions generate for others. The competitive development of golf courses illustrates this point. Because of the beauty and openness of golf courses, many people find it attractive to live near them. Thus, constructing a golf course typically generates an external benefit—an increase in the value of the nearby property. In response, golf course developers have figured out how to capture this benefit. Now they typically purchase a large tract of land around the planned course before it is built. This lets them resell the land at a higher price after the golf course has been completed and the surrounding land has increased in value. By extending the scope of their activities to include real estate as well as golf course development, they can obtain revenues from what would otherwise be external benefits.

As for external costs, simple rules can sometimes help to control them. For example, with respect to disturbing noise from nearby residents, apartment owners often have rules about playing loud music late at night, and they enforce the rules by fining or expelling violators. Manners and social conventions can also play a role. If your roommates are aware that having the television on interferes with your studying, they may have the good manners to turn it off. On a larger scale, over time it has become “socially unacceptable” for companies to emit pollution that harms people and their environment. There is increasing pressure for companies to be good citizens—and private watchdogs such as environmental groups will publicize their actions if they behave irresponsibly.

Another time when no government action is needed to control externalities is when the number of people affected on either side is small and they can negotiate. Suppose your neighbor in the next flat is playing her brass band music so loudly that you cannot study for your economics test. Government could pass a law giving her the right to play music (a property right) or it could pass one giving you the right to peace and quiet, but how would it decide? Free markets will, if not interfered with by government, on the other hand always come up with the seemingly best solution. Suppose you value quiet more than she values music. The answer is simple: you just pay her a bit more than she values playing to shut up. The reverse is also true, if she values music more than you value quiet, she will pay you to wear your ear plugs and suffer. This analysis that externalities can be dealt with by the market if the number of people involved is small by agreement among the parties is the famous “Coase Theorem”.⁽⁸³⁾ Property rights again come to the rescue.

So our analysis indicates that public goods and externalities may undermine the efficient operation of markets. Economists use the term market failure to describe such situations wherein the existing structure of incentives creates a conflict between personal self-interest and economic efficiency—getting the most out of the available resources. Such market failure encourages self-interested decision-makers to engage in counterproductive rather than productive activities.

This market failure creates the potential for government action to improve economic efficiency. But the political process is merely an alternative form of economic organization. Like markets, it has strengths and weaknesses. We need to know more about how that form of organization works so that it can be compared realistically with markets.⁽⁸⁴⁾ We now turn to that topic.