2. Environmental Externalities and Market Failure

The market economy is a fundamental concept of economics. To understand the market economy, it is important to explore the concepts of market failure and externalities. Let us discuss these concepts and their role in environmental economics in detail.

Market Failure

Generally, market failure refers to a situation where the functioning of a perfect market is damaged; as a result, it is unable to distribute limited resources efficiently at a given price since the prerequisites for the laws of demand and supply are not satisfied.
In the case of Environmental Economics, market failure refers to the condition where the costs and benefits of the processes/products that affect the environment do not balance one another. This refers to the situation where the loss of environment exceeds the cost and benefits of a product or service.

Examples:
1. The industries (powered by fossil fuels) often result in environmental degradation, yet it is important for the economy. But if the degradation exceeds the threshold limit, it results in market failure.
2. Another example is a common grazing area or a shared freshwater source. If used in excess, it leads to resource depletion, and thus the scenario of market failure arises.

Externalities

Within the field of Economics, an externality is defined as a side-effect of any process, product or service.
Externalities refer to the unintended consequences of economic activity that have an impact on people and the environment in ways that are not reflected in the market prices. The externalities can be classified into two types: Positive externalities and Negative externalities.

1. Positive Externalities

It refers to the unintended positive impact caused by any economic activities. Any business/ activity that provides benefits not only to the owner but also the local community or environment falls under this category. Some of the examples of positive externalities are as follows:

• Planting trees: Tree plantation by an individual or an organisation always benefits the environment as the trees help to absorb carbon dioxide and thus reduce global warming and thereby combat climate change.
• Bee-keeping: It does not only benefit the owner by providing honey but also helps local farming communities as bees act as pollinators.
• Utilisation of renewable energy: When an organisation adopts renewable energy sources (solar power and wind power), it not only reduces the organisation’s dependency on fossil fuels and reduces its investment costs, but also benefits the environment and society as a whole because it reduces production of GHGs and other air pollutants.

2. Negative Externalities

It occurs when the economic actions of individuals or businesses lead to unintended adverse impacts on the environment It is an unintended consequence of the economic activity that directly impacts the general public even when they are not responsible for it. Some of the examples of negative externalities are:

• Polluting water sources: Industrial activities, such as manufacturing and agriculture discharge their wastewater into the nearby lakes and rivers, polluting them. This causes damage not only to the local people but also to the animals which depend on the same water source.
• Deforestation: Population explosion has led to increased demand for land which in turn has led to more deforestation. Though deforestation satisfies human needs, it has negative impacts on the environment like soil erosion, loss of habitat for wildlife, and climate change. It also impacts future generations who may be devoid of the benefits of the trees.

Externalities can lead to market failures because the price of goods and services does not reflect the full costs or benefits of their production and consumption.

The governments and policymakers can further address externalities through policies such as taxes, subsidies and regulations to manage the external costs or benefits of economic activities and align market prices.