1.2 … and why it sometimes doesn't work so well
For the market to work well, a range of conditions have to be fulfilled. But for our present purposes, one of these is especially important: the property rights in resources used in production have to be clearly assigned and be capable of enforcement at low cost.
A simple example may make this clear. Imagine you live in a society with no taxes on fuel or energy use, where all electricity comes from privately financed coal-fired power stations. When you switch on your kettle, what resources are you using and what does it cost you? You have to pay a price for generating the electricity; part of this cost will be to pay off the costs of building and maintaining the power station, another part for the operation of the power station and part for the mining and transportation of coal to the power station.
In all these cases, you are compensating the owners of property rights for the use of their ‘property’, broadly interpreted to include labour services as well as plant and raw materials. You are destroying coal by having it burned up to supply your electricity, but you have to pay for this because somebody else owns clearly defined property rights in the coal and can easily enforce them.
But you are destroying something else as well, which you will not be asked to pay for: an unpolluted atmosphere. The burning of the fossil fuel releases carbon dioxide into the atmosphere, and, in consequence, causes climate instability. When our actions destroy a scarce resource which we are not required to pay for, we have what economists call an ‘externality’ problem.
The market works well when providing goods for which the full cost to society has to be borne; this obliges consumers to ‘economise’ in their use of the scarce resources used to produce the goods. But because we cannot create, transfer or enforce private property rights in the atmosphere, we have been able to treat it as a free and unlimited resource, when in fact it is scarce and may be irretrievably damaged by the misuse to which the economic incentive system encourages us to subject it.
The concept of externalities is of wide relevance in economics. It is further explained, with particular reference to environmental problems, in an article in The Encyclopedia of Earth.
1 The market