Essay by PaperNerd ContributorUniversity, Master's October 2001

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Long Answer Essay: Pollution is sometimes said to be an example of market failure. What is meant by this? How might governments encourage markets to work towards helping solve environmental problems? Environmental problems such as externalities, or spillovers, are considered to be an example of market failure. An externality is defined: a benefit or cost from production or consumption, accruing without compensation to non-buyers and non-sellers of the product.

Externalities can appear as spillover costs. Production or consumption costs inflicted on a third party without compensation are called spillover costs. Spillover costs often take the form of environmental pollution and are associated with market failure in the economy. For example, when a chemical manufacturer or meatpacking plant dumps its wastes into a lake or river, swimmers, fishermen, and boaters suffer spillover costs. When a petroleum refinery pollutes the air with smoke, the community bears spillover costs for which it is not compensated.

It should first be noted that market failure occurs when the competitive market system a) produces undesired amounts of certain goods and services, or b) fails to allocate any resources whatsoever to the production of certain goods and services whose output is economically justified.

The economic effects of spillover costs dictate market failure. Because costs determine the position of the firm's supply curve, when a firm avoids some costs by polluting, its supply curve lies farther to the right than it does when the firm bears the full costs of production. This result in a larger output than is socially desirable-a market failure in the form of an over allocation of resources to the production of the good. Allocative efficiency is the apportionment of resources among firms and industries to obtain the production of the products most wanted by society; marginal benefit equals marginal cost.