Throughout the book, we have seen that an economy relies on free, competitive markets to provide optimal outcomes for producers and consumers: Firms produce and consumers buy up to the point at which the marginal benefit of the product equals the marginal cost of producing it. When there are externalities or public goods involved, however, this process doesn’t work.

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When one economic actor’s purchase or production decision imposes costs or benefits on other economic actors that are not included in the transaction, these imposed costs and benefits are not taken into account by the decision maker, and free-market outcomes can lead the economy far away from its optimum. There will be too many products with negative externalities and too few products with positive externalities. Common resources and public goods are a bit different from externalities, but the markets for them show many of the same pathologies: overconsumption (of common resources) and underprovision (of public goods).

There are many ways to mitigate or even get rid of the problems associated with market failures. Governments can impose Pigouvian taxes or subsidies on markets with externalities to bring the private costs and benefits in line with the true costs and benefits to society. For common resource and public goods problems, governments can impose quantity restrictions or mandates or even provide a product themselves. However, governments aren’t the only entities that may correct for these market failures. The Coase theorem indicates that, if negotiation costs are low enough, the private sector may itself come up with a closer-to-optimal solution.

The key to this chapter is understanding why some markets may not always work as efficiently as the standard economic models predict. In the last chapter of this book, we examine situations in which economic actors (consumers and producers) may not appear to be the rational, utility- and profit-maximizing agents we have modeled throughout this text.