A simple example illustrates the problem. Markets for most agricultural
commodities are highly competitive, with many small producers who are
unable to affect the price of the goods they are producing. At the same
time, the extensive use of fertilizers in agricultural production pollutes
nearby rivers and lakes. This pollution imposes costs on households who
use the water for drinking and also on the health of local fish populations.
Because these costs are not taken into account in the market for the
agricultural products, they will be external to transactions in those
markets. Generally, when production of a good or service causes
pollution, the quantity produced in a perfectly competitive industry will
exceed the efficient amount.
Market failures exist in many parts of the economy. One of the most important issues in public
policy is determining the circumstances in which government action can increase allocative
efficiency in these situations.As we will see later in this book, there are many circumstances in which
there is room for public policy to increase the efficiency of market
outcomes, but there are also many cases in which the cure is worse than
the disease. In the remainder of this chapter we examine economic
regulation and competition policy, both of which are designed to promote
allocative efficiency.