The market failures examined in thi

The market failures examined in this chapter fall under a general category
called externalities. An externalityarises when a person engages in an activity
that influences the well-being of a bystander but 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 pres-ence 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. Here are some examples:
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