Introduction

The last two chapters focused on the connections between the market mechanism and Pareto optimality. We showed that in exchange and in production, the free market leads to efficiency, and that any efficient situation can be achieved via a slightly modified market mechanism. These important results relied on some equally important assumptions. One assumption was that all the parties in the economy must act competitively; they must all assume that prices are given and fixed, beyond their control. We know that when the assumption of competitive behavior breaks down, as with monopoly, duopoly, or oligopoly, the market does not lead to efficiency. The behavior of a monopolist, or, more generally, the noncompetitive behavior of any player in a market, leads to what is called market failure.

In this chapter, we examine another very important kind of market failure, the kind produced by externalities.

When we analyzed trade between two people, we assumed that person i's utility depended only on his bundle of goods, and not on person j 's. When we analyzed production by firms, we assumed that firm i's costs and output depended only on its inputs, and not on the inputs or outputs of firm j. When we analyzed the interactions between firms and consumers, we assumed that a consumer buying a firm's output cared only about how much he consumed, and the price he paid. If the consumer was selling labor to the firm, he cared only about the quantity he was selling, and the price he received.