BY THE MIDDLE OF THE NINEteenth century, London had become the world’s largest city, with close to 2.5 million inhabitants. Unfortunately, all those people produced a lot of waste—and there was no place for it to go except into the Thames, the river flowing through the city. Nobody with a working nose could ignore the results. And the river didn’t just smell bad—it carried dangerous waterborne diseases like cholera and typhoid. London neighbourhoods close to the Thames had death rates from cholera more than six times greater than the neighbourhoods farthest away. And the great majority of Londoners drew their drinking water from the Thames.

What the city needed, said reformers, was a sewage system that would carry waste away from the river. Yet no private individual was willing to build such a system, and influential people were opposed to the idea that the government should take responsibility for the problem. For example, the magazine The Economist weighed in against proposals for a government-built sewage system, declaring that “suffering and evil are nature’s admonitions—they cannot be got rid of.”

But the hot summer of 1858 brought what came to be known as the Great Stink, which was so bad that one health journal reported “men struck down with the stench.” Even the privileged and powerful suffered: Parliament met in a building next to the river. After unsuccessful efforts to stop the smell by covering the windows with chemical-soaked curtains, Parliament finally approved a plan for an immense system of sewers and pumping stations to direct sewage away from the city.

The system, opened in 1865, brought dramatic improvement in the city’s quality of life; cholera and typhoid epidemics, which had been regular occurrences, completely disappeared. The Thames was turned from the filthiest to the cleanest metropolitan river in the world, and the sewage system’s principal engineer, Sir Joseph Bazalgette, was lauded as having “saved more lives than any single Victorian public official.” It was estimated at the time that Bazalgette’s sewer system added 20 years to the lifespan of the average Londoner.

The story of the Great Stink and the policy response that followed illustrate two important reasons for government intervention in the economy. London’s new sewage system was a clear example of a public good—a good that benefits many people, whether or not they have paid for it, and whose benefits to any one individual do not depend on how many others also benefit. As we will see shortly, public goods differ in important ways from the private goods we have studied so far—and these differences mean that public goods cannot be efficiently supplied by the market.

In addition, clean water in the Thames is an example of a common resource, a good that many people can consume whether or not they have paid for it but whose consumption by each person reduces the amount available to others. Such goods tend to be overused by individuals in a market system unless the government takes action.

In earlier chapters, we saw that markets sometimes fail to deliver efficient levels of production and consumption of a good or activity. We saw how inefficiency can arise from market power, which allows monopolists and colluding oligopolists to charge prices that are higher than marginal cost, thereby preventing mutually beneficial transactions from occurring. We also saw how inefficiency can arise from positive and negative externalities, which cause a divergence between the costs and benefits of an individual’s or industry’s actions and the costs and benefits of those actions borne by society as a whole.

In this chapter, we will take a somewhat different approach to the question of why markets sometimes fail. Here we focus on how the characteristics of goods often determine whether markets can deliver them efficiently. When goods have the “wrong” characteristics, the resulting market failures resemble those associated with externalities or market power. This alternative way of looking at sources of inefficiency deepens our understanding of why markets sometimes don’t work well and how government can take actions that increase society’s welfare.