Chapter Introduction


Externalities and Public Goods



London’s River Thames then …… and the same river now, thanks to government intervention.

What You Will Learn in This Chapter

  • What externalities are and why they can lead to inefficiency and government intervention in the market

  • The importance of the Coase theorem, which explains how private individuals can sometimes remedy externalities

  • Why some government policies to deal with externalities, like emissions taxes, tradable emissions permits, or Pigouvian subsidies, are efficient and others, like environmental standards, are not

  • The difference between private goods, which can be efficiently provided by markets, and public goods, which markets fail to supply

image | interactive activity

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 neighborhoods close to the Thames had death rates from cholera more than six times greater than the neighborhoods farthest away. And the great majority of Londoners drew their drinking water from the Thames.

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 and unsuccesfully attempted 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.

By dumping waste into the Thames, individuals imposed costs on all of the residents of London. When individuals impose costs on or provide benefits for others, but don’t have an economic incentive to take those costs or benefits into account, economists say that externalities are generated.

In this chapter, we’ll examine the economics of externalities, seeing how they can get in the way of economic efficiency and lead to market failure, why they provide a reason for government intervention in markets, and how economic analysis can be used to guide government policy.

The story of the Great Stink also illustrates an important reason 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, 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.