The discussion in the textbook (Ch.10) and in the lectures leads to the conclusion that markets don't always allocate resources to produce the socially efficient outcome.
When this happens we talk about market failure. This supplement provides a more detailed discussion of the market failure associated with pollution than Mankiw in Chapter 10.
In the next section we discuss pollution from an economic perspective. The third section traces the sources of this type of market failure. This is followed in the fourth section by a discussion of potential solutions to this problem.
POLLUTION AS MARKET FAILURE
Pollution can occur in many forms. Factories discharge waste into the atmosphere in the form of sulphurous smoke depositing particles in the surrounding area or at a distance. They also deposit waste liquids containing chemicals into rivers. Individuals also cause pollution by depositing waste (including litter) in streets or in rivers and canals. Pollution can also take the form of sound pollution: playing loud music in otherwise quiet locations to the annoyance of others. There is also the emission of so-called greenhouse gases which deplete the ozone layer contributing to the greenhouse effect. Accidents at sea resulting in oil spillage and contamination of the sea endangering sea and bird life is yet another form of pollution.
Each of these forms of pollution has the common feature that it is, by-and-large, an unintended consequence of a legitimate activity. It is an indirect effect. From an economic perspective the activity of one or more economic agent affects the utility or costs of another economic agent in a way which does not affect the original agent's costs or utility. Consequently the first agent does not take account of the effect on the second agent when determining the level of the activity to be undertaken. The level of activity will be determined by the first agent equating marginal benefit to marginal...