How do you incorporate externalities and public goods into market equilibrium analysis and policy making?

Incorporating externalities and public goods into market equilibrium analysis and policy making is essential for a balanced economy. Externalities are side effects of economic activities that affect third parties—like pollution or education benefits. When analyzing markets, I account for these impacts to ensure policies address both the costs and benefits that aren’t reflected in market prices. This approach helps create more effective regulations and fosters sustainable economic growth. Understanding and integrating these factors is key to smart policy making!

Externalities are welfare effects that impact agents unrelated to an economic decision, and that will therefore be unable to influence it. Pollution is the textbook example of negative externality. A factory does not face the full costs of the pollution it emits (part of it is felt as a health effect by people living in the vicinity), making the level of pollution higher than the social optimum. The consequence of that is that the market result will be inefficient. Ie, there is more pollution than there would otherwise be if polluters had to pay third parties for the negative effects they are causing. A positive externality is the opposite: an economic decision causes a positive effect on third parties, leading to too little of it.

Correcting externalities is crucial for creating more efficient markets. One way is through taxes or subsidies—taxing negative externalities like pollution to discourage harmful activities, or subsidizing positive externalities like education to encourage beneficial ones. Regulations and standards also play a role in limiting negative impacts. Another approach is creating markets for externalities, like cap-and-trade systems for carbon emissions

Negative externalities can be corrected by imposing (Pigouvian) taxes. This way a government makes a polluter feel the indirect costs of their decisions. In practice, however, there a few problems with this: Pigouvian taxes may be hard to calibrate, they may get mixed up with other policy objectives, and may create the opportunity of corruption. An alternative to this is found by realizing externalities are a case of missing markets. Cap-and-trade systems define the maximum amount of pollution that can be emitted, and distribute 'pollution rights' to different firms. They may buy and sell these rights, ensuring that pollution is emitted where it is most needed.

Public goods are unique because they’re non-excludable and non-rivalrous—meaning everyone can use them, and one person’s use doesn’t reduce availability for others. Think of clean air, national defense, or public parks. These goods are typically provided by the government because the market wouldn’t supply them efficiently on its own.

Public goods are goods that once they exist, they can be freely used by anyone. Ie, you can't prevent anyone from using it (non-excludable), and usage does not decrease its availability to anyone else (non-rivalrous). An example is public safety: if a city is safe, everyone benefits and one person being safe does not reduce another's safety. The problem with public goods is that these characteristics make them prone to sub-provision by the market. There is no way for a private entity to provide public safety and charge people individually for this diffuse benefit.

Providing public goods is crucial for societal well-being. Since markets often fail to supply these goods efficiently, governments step in. Funding typically comes from taxes, ensuring everyone contributes to and benefits from resources like clean air, national defense, and public parks. Public-private partnerships can also be effective, combining government oversight with private sector innovation. The goal is to make sure these essential resources are available to all, fostering a healthier and more equitable society.