Competitive markets are remarkably efficient, but they do not always produce socially desirable outcomes. A market failure occurs when the market equilibrium does not maximize total surplus, and the most common source is externalities, costs or benefits that fall on third parties who are not part of the transaction. A negative externality, such as pollution from a factory, means that the social cost of production exceeds the private cost borne by the producer. As a result, the market produces more than the socially optimal quantity and creates deadweight loss. A positive externality, such as education or vaccinations, means that the social benefit exceeds the private benefit received by the consumer, so the market produces less than the socially optimal quantity.
Public policy can address these gaps. A Pigovian tax is a per-unit tax equal to the external cost of a negative externality, designed to internalize the externality and bring private decisions in line with the social optimum. Symmetrically, a Pigovian subsidy, a per-unit payment equal to the external benefit, can be used to encourage activities with positive externalities. An alternative, articulated by the Coase Theorem, holds that if property rights are well defined and transaction costs are low, the affected parties can bargain privately to reach an efficient outcome regardless of who initially holds the rights.
Some goods are particularly prone to market failure because of their special properties. A public good is both non-excludable, meaning no one can be effectively prevented from using it, and non-rivalrous, meaning one person's use does not diminish availability for others. National defense is the classic example. Because people cannot be excluded, individuals have an incentive to free ride, benefiting without paying, which leads to under-provision by private markets. A common resource, such as fish in the ocean, is rivalrous but non-excludable, and overuse leads to the tragedy of the commons, in which individuals deplete the shared resource because they do not bear the full social cost of their consumption. A club good sits in between: it is excludable but non-rivalrous up to a point, as with cable television or uncongested toll roads. Understanding these categories helps explain why certain goods are best provided by governments, while others can be efficiently managed through markets, bargaining, or collective action.