Firms that make and sell paper also create, as a by-product of the manufacturing process, a chemical
called dioxin. Scientists believe that once dioxin enters the environment, it raises the population's risk of
cancer, birth defects, and other health problems.
Is the production and release of dioxin a problem for society? In Chapters 4 through 9, we examined how
markets allocate scarce resources with the forces of supply and demand, and we saw that the equilibrium of
supply and demand is typically an efficient allocation of resources. To use Adam Smith's famous metaphor,
the "invisible hand" of the marketplace leads self-interested buyers and sellers in a market to maximize the
total benefit that society derives from that market. This insight is the basis for one of the Ten Principles of
Economics in Chapter 1: Markets are usually a good way to organize economic activity. Should we
conclude, therefore, that the invisible hand prevents firms in the paper market from emitting too much
Markets do many things well, but they do not do everything well. In this chapter, we begin our study of
another of the Ten Principles of Economics: Government action can sometimes improve upon market
outcomes. We examine why markets sometimes fail to allocate resources efficiently, how government
policies can potentially improve the market's allocation, and what kinds of policies are likely to work best.
The market failures examined in this chapter fall under a general category called externalities. An
externality arises when a person engages in an activity that influences the well-being of a bystander and yet
neither pays nor receives any compensation for that effect. If the impact on the bystander is adverse, it is
called a negative externality. If it is beneficial, it is called a positive externality. In the presence of
externalities, society's interest in a market outcome extends beyond the well-being of buyers and sellers who
participate in the market to include the well-being of bystanders who are affected indirectly. Because buyers
and sellers neglect the external effects of their actions when deciding how much to demand or supply, the
market equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize the
total benefit to society as a whole. The release of dioxin into the environment, for instance, is a negative
externality. Self-interested paper firms will not consider the full cost of the pollution they create in their
production process, and consumers of paper will not consider the full cost of the pollution they contribute
from their purchasing decisions. Therefore, the firms will emit too much pollution unless the government
prevents or discourages them from doing so.
Externalities come in many varieties, as do the policy responses that try to deal with the market failure.