Market failure: externalities and common pool or common access resources

• Explain why resources are allocated efficiently at the output where MSB = MSC, and show it on a diagram.
• Draw and explain each of the four externalities, identifying the market output, the socially optimum output and the welfare loss.
• Explain why merit goods are under-consumed and demerit goods are over-consumed.
• Explain why open access leads to the overuse of common pool resources, and why this is a threat to sustainability.
• Explain how each response works, with a diagram for taxes, carbon taxes, subsidies, regulation and education.
• Evaluate the responses in terms of measurement, effectiveness and the consequences for stakeholders.
• Discuss why global sustainability problems need international cooperation and why it is hard to secure.

A market achieves Allocative efficiency when it produces the quantity at which the benefit to society of the last unit equals its cost to society. Stating this precisely needs four curves. In each name, marginal means 'of one more unit'.

• Marginal private cost (MPC): the cost to producers of supplying one more unit (their Private cost). Firms decide how much to sell from their own costs, so the supply curve is the MPC curve. In macroeconomics the letters MPC stand for the marginal propensity to consume, which is unrelated.
• Marginal social cost (MSC): the cost to society of one more unit (the Social cost): MPC plus any external cost that production imposes on third parties, or minus any external benefit that it gives them.
• Marginal private benefit (MPB): the benefit to consumers of one more unit (their Private benefit). Consumers decide how much to buy from their own benefit, so the demand curve is the MPB curve.
• Marginal social benefit (MSB): the benefit to society of one more unit (the Social benefit): MPB plus any external benefit that consumption gives to third parties, or minus any external cost that it imposes on them.

An Externality is a cost or benefit of producing or consuming a good that falls on a third party, someone who is neither the buyer nor the seller, and that is not reflected in the market price. Because buyers and sellers neither pay for it nor are paid for it, they ignore it when they decide how much to trade.

With no externality, MPC = MSC and MPB = MSB. The competitive market equilibrium, where demand (MPB) meets supply (MPC), is then also the point where MSB = MSC. This quantity is the Socially optimum output. For every unit up to it, the benefit to society is at least as great as the cost; for any unit beyond it, the cost would be greater than the benefit. Social surplus, the sum of consumer surplus and producer surplus, is therefore as large as it can be, and neither too much nor too little of the good is produced.

A Market failure occurs when the free market allocates resources to a quantity at which MSB does not equal MSC. An externality causes one: it separates a private curve from its social curve, so the market equilibrium, where MPB = MPC, is no longer at the optimum, and social surplus is below its maximum. The shortfall is the Welfare loss. The analysis assumes that the market is otherwise competitive, so that the externality is the only reason for the market output to differ from the optimum.

Every externality diagram can be built from four decisions, taken in this order.

1. Production or consumption? An externality of production separates the cost curves, on the supply side. An externality of consumption separates the benefit curves, on the demand side.
2. Negative or positive? Negative, of production: MSC above MPC. Negative, of consumption: MSB below MPB. Positive, of production: MSC below MPC. Positive, of consumption: MSB above MPB.
3. Mark the market output Qm where MPB = MPC, and the socially optimum output Qopt where MSB = MSC.
4. The welfare loss is the triangle between the MSB and MSC curves, from Qopt to Qm. Its point is at the social optimum and its vertical side is at Qm.

A Negative externality is a cost that the production or consumption of a good imposes on third parties, who receive no compensation for it. Where the cost arises decides which pair of curves separates.

Negative externality of production. A coal-fired power station emits smoke that damages the health of people living nearby. The firm pays for its coal, labour and equipment, but not for this damage. The cost to society of each unit of electricity is therefore greater than the cost to the firm: marginal social cost (MSC) lies above marginal private cost (MPC) by the external cost per unit.

Firms supply according to MPC, so the market settles at the output Qm and the price Pm, where MPB = MPC. The socially optimum output is the smaller quantity Qopt, where MSB = MSC, at the higher price Popt. The market overproduces. For every unit between Qopt and Qm, MSC is greater than MSB, and the sum of those gaps is the welfare loss.

Negative externality of consumption. A person who smokes in a shared space harms the health of the people nearby. A driver who uses a busy road adds to the delay and the exhaust fumes that other people suffer. Here the harm comes from using the good, not from making it. The benefit to society of each unit consumed is less than the benefit to the consumer: marginal social benefit (MSB) lies below marginal private benefit (MPB) by the external cost per unit.

Consumers buy according to MPB, so the market settles at Qm, where MPB = MPC. The optimum Qopt, where MSB = MSC, is smaller. The market over-consumes, and the welfare loss is again the sum of the gaps between MSC and MSB from Qopt to Qm.

In both cases the market quantity is too high, but the prices compare differently. With an externality of production the market price Pm is below Popt: buyers pay less than the full cost to society. With an externality of consumption the optimum lies lower down the supply curve, so Popt is below Pm on the diagram. A lower price would not cure the problem, however. Popt is the price producers would need to receive to supply only Qopt, and consumers would buy as little as Qopt only if the price they paid were higher than Pm. A tax creates that difference between the two prices.

Demerit goods are goods whose consumption is judged to be harmful to the consumer and which usually also impose costs on other people. Tobacco, alcohol, sugary drinks and gambling are the usual examples. They are over-consumed in a free market for two reasons. Consumers ignore the costs to third parties, which is a negative externality of consumption. And many consumers underestimate the long-term harm to themselves, because their information is imperfect or because the product is addictive. A demerit good is drawn with the diagram of a negative externality of consumption.

Not every good with a negative externality is a demerit good. The pollution from making steel is an externality of production, and steel does no harm to the people who buy it.

• Third parties bear costs that they did not agree to: illness, noise, delay and a damaged environment.
• Producers and consumers of the good gain from a price that leaves these costs out, which is why they have no reason to change their behaviour without intervention.
• The government, and therefore taxpayers, pays part of the cost through spending on health care and on cleaning up.

A Positive externality is a benefit that the production or consumption of a good gives to third parties, who do not pay for it. Because the producer or consumer is not rewarded for this benefit, too little of the good is produced or consumed.

Positive externality of production. A firm that trains its workers bears the cost of the training, but some of the workers later move to other firms, which gain skilled employees without paying for their training. A firm whose research produces new knowledge finds that other firms learn from it and build on it. In both cases part of what the firm spends creates benefits elsewhere, so the cost to society of its output is less than the cost to the firm: marginal social cost (MSC) lies below marginal private cost (MPC) by the external benefit per unit.

Firms supply according to MPC, so the market settles at Qm, where MPB = MPC. The socially optimum output Qopt, where MSB = MSC, is larger, and would be sold at a lower price. The market underproduces.

Positive externality of consumption. A person who is vaccinated is protected from a disease and also cannot pass it on, so people who are not vaccinated are safer. A person who is educated earns more and is also a more productive colleague and a better-informed citizen. The benefit to society of each unit consumed is greater than the benefit to the consumer: marginal social benefit (MSB) lies above marginal private benefit (MPB) by the external benefit per unit.

Consumers buy according to MPB, so the market settles at Qm, where MPB = MPC, which is less than Qopt, where MSB = MSC. The market under-consumes.

In both cases the market quantity is too low, and the welfare loss has a different meaning from the negative case. No harm is done by the units that are produced. The loss consists of the units between Qm and Qopt that are not produced, although each of them would add more to society's benefit than to its cost. The triangle is welfare that could be gained and is not.

Merit goods are goods judged to be beneficial for consumers and for society, which are under-consumed in a free market. Education, health care and vaccination are the standard examples. A merit good is drawn with the diagram of a positive externality of consumption. There are three reasons for the under-consumption.

• Consumers ignore the benefit to third parties. This is the positive externality of consumption, shown by the gap between MSB and MPB.
• Consumers have imperfect information and underestimate the benefit to themselves, which is often long-term or uncertain, as with the higher lifetime income that more education brings. Their demand is lower than it would be if they were fully informed.
• Households on low incomes may be unable to pay the market price even when they know the value of the good, because demand requires the ability to pay as well as the willingness.

A Common pool resource (also called a common access resource) is a resource that is Rivalrous and Non-excludable. Rivalrous means that one person's use reduces the amount available to others: a fish caught by one boat cannot be caught by another. Non-excludable means that nobody can be prevented from using the resource or charged for using it: no one owns the open ocean. A good is Excludable when people who do not pay can be kept from using it. Ocean fish stocks, forests, grazing land, groundwater, clean air and the atmosphere's capacity to absorb greenhouse gases are common pool resources.

The two characteristics together create the Tragedy of the commons. Because the resource is non-excludable, no price is charged for using it. Each user therefore receives the whole benefit of taking a little more, while the cost of the depletion is spread over all users, now and in the future. The private incentive of each user is to take more than the resource can replace. Holding back does not help the individual, since others take what is left. When every user follows this incentive, the resource is degraded or destroyed, although all of them would be better off if all held back.

A market cannot correct this without help. Markets ration scarce goods through prices, and prices exist only for things that are owned and sold. With no owner and no price, nothing signals that the resource is becoming scarce and nothing rewards a user for conserving it.

The unsustainable use of a common pool resource is a negative externality of production. A fishing fleet that overfishes, a firm that clears forest and a power station that burns fossil fuels each use up a shared resource without paying for it, and the cost falls on other users and on future generations. On the diagram, marginal social cost (MSC) lies above marginal private cost (MPC), the market output Qm is greater than the socially optimum output Qopt, and there is a welfare loss.

Because part of the cost falls on people who are not yet born, overuse is also a threat to Sustainability: the resource is used at a rate that leaves future generations with less than the present generation enjoyed. Fish stocks and forests are renewable, so they can be used indefinitely as long as the rate of use stays below the rate at which they are replaced.

A market with a negative externality fails because nobody pays the external cost. Market-based responses put a price on that cost, so that the people who cause it take it into account in their own decisions. The cost is then said to be internalised. Three responses work in this way: an indirect tax, a carbon tax and tradable permits.

A Pigouvian tax is an Indirect tax charged on each unit of a good that creates a negative externality, set equal to the external cost per unit. Take a negative externality of production. The tax raises firms' costs by the amount of the tax, so the supply curve, S = MPC (marginal private cost), shifts vertically upward to MPC + tax. If the tax equals the external cost, the new supply curve lies on MSC. The price rises from Pm to Popt, quantity demanded contracts along the demand curve, and output falls from Qm to Qopt. The welfare loss disappears, and the government collects revenue equal to the tax per unit multiplied by Qopt.

The same tax corrects a negative externality of consumption, such as the harm done by a demerit good, although the diagram is different. The tax is still collected from sellers, so it is still the supply curve that shifts, from S to S + tax. The price that consumers pay rises, and they move up along D = MPB until the quantity bought is Qopt. Consumers pay a higher price than before, producers keep a lower one, and the difference between the two is the tax.

• Strength: The tax works through the price signal. Each firm and consumer decides how to respond to the higher price, so the fall in quantity comes from those who value the good least or who can switch to something else most cheaply.
• Strength: It raises revenue, which can pay for health care, for cleaning up the damage or for compensating those harmed. A regulation that achieved the same fall in quantity would raise none.
• Strength: If it is charged on emissions, per tonne of pollutant, and not on output, firms can cut their tax bill by producing more cleanly. The external cost of each unit then falls, as well as the number of units.
• Limit: The external cost must be given a money value before the rate can be set, which means valuing illness, lives and environmental damage. A tax set too low leaves part of the welfare loss in place; a tax set too high pushes output below Qopt and creates a new welfare loss.
• Limit: The fall in quantity depends on Price elasticity of demand (PED). Where demand is price inelastic, as for petrol and cigarettes, which have few close substitutes or are addictive, quantity falls by a smaller percentage than price rises. The tax raises a large revenue but leaves most of the over-consumption in place.
• Limit: An indirect tax on a necessity or an addictive good is regressive: low-income households spend a larger share of their income on goods such as fuel and tobacco, so the tax takes a larger share of their income.
• Limit: A high tax in one country gives buyers and firms a reason to go elsewhere. Goods such as cigarettes are smuggled and sold illegally, and firms may move production to countries without the tax.

A Carbon tax is a Pigouvian tax aimed at one pollutant. It is charged on the carbon content of fossil fuels, so a fuel that releases more carbon dioxide when burned, such as coal, is taxed more heavily than a cleaner fuel such as natural gas. It is usually collected from the firms that supply the fuels. The required diagram shows the market of one polluting industry. In the market for coal-fired electricity the tax raises the cost of every unit generated, supply shifts up from S = MPC to MPC + carbon tax, the price rises and output falls toward Qopt.

A carbon tax does more than reduce the output of polluting goods. Because the tax bill depends on the carbon burned and not on the number of units sold, every firm and household has an incentive to switch to lower-carbon fuels and to use energy more efficiently. Demand rises in the markets for low-carbon substitutes, and the external cost of each unit of output falls.

• Strength: The price of emitting is known in advance, so firms can plan investment in cleaner technology knowing what each tonne of emissions will cost them.
• Strength: It can cover the whole economy, including households and transport, because it is collected from a small number of fuel suppliers. This also makes it cheap to administer.
• Strength: The revenue can be returned to households or used to reduce other taxes, which offsets the regressive effect of higher energy prices.
• Limit: The quantity of emissions that results is uncertain. In the short run households and firms cannot easily replace vehicles, boilers and machinery, so demand for energy is price inelastic and emissions fall little. As substitutes are adopted over time, demand becomes more elastic and the fall grows.
• Limit: The correct rate cannot be measured, because the damage from a tonne of carbon dioxide is spread over decades and over the whole world. In practice the rate is a political decision.
• Limit: Firms that use a lot of energy lose competitiveness against rivals in countries with no carbon tax. If production moves abroad, world emissions do not fall; this is called carbon leakage. Exempting those firms protects jobs but weakens the tax exactly where emissions are large.
• Limit: The tax is visible in fuel and heating bills and falls most heavily on low-income households, so it is unpopular and can be cut or abolished by a later government.

Tradable permits (also called cap and trade) work on the quantity instead of the price. The government, or an international authority, sets a cap on the total emissions of a pollutant and issues permits that add up to the cap. A firm must hold one permit for each tonne it emits. Permits are given to firms or sold to them at auction, and they can then be bought and sold, so a market price for emitting appears.

Trading is what keeps the cost down. A firm that can cut a tonne of emissions for less than the permit price does so and sells the spare permit. A firm for which cutting a tonne costs more than the permit price buys permits instead. The total reduction required by the cap is therefore made by the firms that can make it most cheaply. The authority lowers the cap over time, which raises the permit price and the incentive to invest in clean technology.

A tax and a permit scheme create the same incentive in two different ways. A tax fixes the price of emitting and lets the market decide the quantity. A permit scheme fixes the quantity and lets the market decide the price.

• Strength: The total quantity of emissions is certain, because it is set by the cap. This matters when a specific target has to be met.
• Strength: A given reduction is achieved at the lowest total cost, since each firm chooses between cutting its emissions and buying permits.
• Strength: A firm that cuts emissions can sell permits, so the incentive to do better never ends, and auctioning the permits raises revenue for the government.
• Limit: The scheme is only as strict as its cap. If too many permits are issued, the permit price is too low to change behaviour, and firms lobby for a generous cap.
• Limit: The permit price moves with demand, falling in a recession and rising in a boom, which makes the return on an investment in clean technology uncertain.
• Limit: Permits given away free hand a valuable asset to existing polluters, and a new firm that has to buy permits is at a disadvantage against them.
• Limit: The emissions of every firm in the scheme must be measured and checked, so schemes usually cover only large emitters such as power stations and heavy industry, and miss households and small firms.

Governments can also act on behaviour directly. Legislation and regulation use the law to forbid, limit or require something. Examples are limits on the emissions of each factory or vehicle, bans on harmful substances, required technology such as filters, fishing quotas and closed seasons, protected areas, bans on smoking in enclosed public places, minimum ages for buying alcohol and tobacco, and restrictions on advertising. Firms and consumers that break the rules face fines or the loss of a licence.

On the diagram of a negative externality of production, rules that force firms to clean up raise their private costs, so supply shifts up from S1 = MPC toward MSC and output falls from Qm toward Qopt. A rule that restricts output itself, such as a quota, limits the quantity directly. For a negative externality of consumption, rules that restrict who may buy the good, where it may be used or how it is advertised reduce demand: D = MPB shifts left toward MSB.

• Strength: Regulation is direct and quick, and its effect on quantity is more predictable than that of a tax, which works only as far as buyers and sellers respond to the price.
• Strength: No money value has to be put on the external cost. The government has to decide only how much of the activity to allow.
• Strength: It is the appropriate response where the harm is so severe that the optimum quantity is close to zero, as with a poison in drinking water. A ban achieves this; a tax would let anyone who was willing to pay continue.
• Limit: Rules work only if they are monitored and enforced. Inspectors, testing and courts are costly, and where the chance of being caught is low, firms ignore the rule or the trade moves to an illegal market.
• Limit: A standard gives no incentive to do better than the standard. A firm that meets the limit gains nothing by cutting emissions further, whereas under a tax or a permit scheme every extra tonne cut saves money.
• Limit: The same rule for every firm is not the cheapest way to reach a given total reduction, because firms that could cut emissions cheaply are asked to do no more than firms for which cutting is very expensive.
• Limit: Setting a standard needs technical information that firms have and regulators lack, and firms lobby for exemptions and delays. Regulation also raises no revenue.

Education and awareness-raising try to change what consumers believe, and therefore what they choose. Examples are health warnings on cigarette packets, labels showing the sugar content of food or the energy use of an appliance, public campaigns on drink-driving or recycling, and school programmes. They deal with imperfect information, which is one reason why demerit goods are over-consumed and merit goods under-consumed.

For a demerit good, a successful campaign reduces demand at every price, so D = MPB shifts left toward MSB and the quantity falls toward Qopt. For a merit good such as vaccination, a campaign shifts D = MPB right toward MSB and the quantity rises toward Qopt. In both cases it is the demand curve that moves, because tastes and information are non-price determinants of demand.

• Strength: It acts on a root cause. If people over-consume because they underestimate the harm, better information changes their behaviour without any need to keep enforcing a rule or collecting a tax.
• Strength: It leaves choice free and does not raise prices, so it places no extra burden on low-income consumers and is politically easy to introduce.
• Strength: It supports other policies. Consumers who understand why a good is taxed or restricted are more likely to respond to the tax and to accept the rule.
• Limit: The effect is slow and uncertain. Habits and tastes change over years, and a campaign has little effect on consumers who are addicted or who already know the risks.
• Limit: It does nothing about the external cost itself. A consumer who is fully informed about the harm to others still does not pay for it, so some over-consumption remains even after a successful campaign.
• Limit: Campaigns cost money that has an opportunity cost, and their effect is hard to separate from other influences on demand, so it is difficult to know whether the spending was worthwhile.

Taxes, permits and regulation are aimed mainly at goods that are over-produced or over-consumed. For goods with positive externalities, including merit goods, the aim is the opposite: to raise the quantity from Qm to Qopt. The two main responses are subsidies and government provision.

A Subsidy is a payment from the government to firms for each unit they produce. Take a good with a positive externality of consumption, such as vaccination. The subsidy lowers firms' costs, so the supply curve shifts vertically downward from S to S − subsidy. The market price falls from Pm to Pc, and consumers move down along D = MPB and buy more. If the subsidy per unit equals the external benefit per unit, the quantity rises to Qopt and the welfare loss is removed. For a positive externality of production, such as research, the subsidy moves S = MPC down toward the MSC curve below it, with the same result: output rises from Qm toward Qopt.

Subsidies are also used against negative externalities, by making a cleaner substitute cheaper. A subsidy for solar panels, electric vehicles or public transport increases the supply of that good. As its price falls, some consumers switch to it, and demand for the polluting good falls.

• Strength: A subsidy raises the consumption of a merit good toward the optimum while leaving consumers free to choose, and it reaches everyone who buys the good.
• Strength: The lower price improves access for low-income households, so the subsidy serves equity as well as efficiency.
• Limit: The spending has an Opportunity cost: the same money could have paid for other public services, and it has to be raised through taxes or borrowing.
• Limit: The external benefit is hard to measure, so the correct size of the subsidy is uncertain. Too small a subsidy leaves part of the welfare loss; too large a subsidy pushes consumption beyond Qopt.
• Limit: Where demand is price inelastic, the lower price raises the quantity only a little, and most of the spending goes to people who would have bought the good anyway.
• Limit: Consumers do not receive the whole subsidy. With an upward-sloping supply curve the price they pay falls by less than the subsidy per unit, and the rest goes to producers as a higher price received. Once firms depend on a subsidy it is also politically difficult to remove.

With government provision the state supplies the good itself, or pays for it in full, and makes it available free or at a low price. Vaccination programmes, state schools, public health services and public parks are examples. The government does not rely on a lower price to draw out more consumption: it decides the quantity to provide and pays for it from tax revenue. On the diagram, total supply shifts right from S1 to S2 until the quantity reaches Qopt at a lower price.

Provision is chosen over a subsidy when the external benefit is very large, when the aim is that everyone should consume the good whatever their income, or when consumers would not buy enough even at a low price because they undervalue the good.

• Strength: Access does not depend on income, so the people least able to pay, whom the market would leave out, are included.
• Strength: The government controls the quantity directly and can make consumption universal or compulsory, as with schooling up to a minimum age.
• Limit: The opportunity cost is large, because the whole cost of the good falls on the government's budget.
• Limit: At a zero price the quantity demanded may exceed the quantity provided. The shortage shows up as waiting lists and crowded services.
• Limit: The government has no market price to tell it how much to provide or what quality consumers want, and a provider with a guaranteed budget has weaker incentives to control its costs than a firm that faces competition.

A common pool resource is overused because nobody owns it and nobody is charged for using it. Governments can respond with the policies used against any negative externality: legal limits such as fishing quotas, licences and closed seasons; taxes on the use of the resource; and tradable permits, which share out a capped total. Two further responses matter where government action is too costly or does not reach far enough: management by the users themselves, and agreements between governments.

Collective self-governance means that the users of a common pool resource agree their own rules for using it, check that the rules are kept and punish those who break them. No private owner and no government regulator is involved. The economist Elinor Ostrom studied fisheries, forests, pastures and irrigation systems that communities had managed in this way, sustainably, over long periods. Her work showed that the tragedy of the commons is not inevitable. It is what happens when users cannot communicate or make agreements that bind them, and many communities can do both.

Self-governance succeeds under particular conditions.

• The group of users and the boundary of the resource are clearly defined, and outsiders can be kept out. Those who bear the cost of holding back are then the ones who gain from it.
• The rules are made by the users and fit local conditions, so they are seen as fair and are followed willingly.
• Users can observe one another at low cost, and penalties start small and rise for repeated offences.
• The group is small and stable enough for its members to trust one another and to expect to depend on the resource in the future.
• Outside authorities accept the community's right to make and enforce its own rules.

• Strength: It uses the knowledge of the people who know the resource best, and it costs the government almost nothing to run.
• Strength: Rules that users have made themselves are seen as legitimate, so compliance tends to be higher than with rules imposed from outside.
• Limit: It breaks down when the conditions fail: when the population grows quickly, when outsiders can enter, or when rising outside demand makes breaking the rules very profitable.
• Limit: It cannot be scaled up to resources used by millions of people who never meet, such as the oceans and the atmosphere.

Many threats to Sustainability cross borders. Greenhouse gases mix in the atmosphere wherever they are emitted, fish stocks move between national waters and the open ocean, and rivers carry pollution from one country into the next. The atmosphere is a global common pool resource. A national tax, permit scheme or regulation reaches only the emitters inside that country, so even a well-designed national policy leaves most of a global externality in place. International cooperation is therefore essential for sustainability: a shared resource is protected only if most of its users act.

Cooperation is hard to achieve because of the incentives that each government faces. A country that cuts its emissions bears the whole cost, in higher energy prices and lost output, but receives only a small share of the benefit, which is spread across every country. Each country is better off if the others cut and it does not: it can free ride on their efforts. If every government reasons in this way, too little is done. This is the tragedy of the commons repeated at the level of countries.

An International agreement tries to change these incentives by committing many countries at once. Agreements set targets or limits, timetables and rules for reporting, and some provide finance and technology for lower-income countries. Reaching an agreement is difficult for several reasons.

• Countries disagree about who should cut most. Lower-income countries argue that the countries which industrialised first are responsible for most past emissions and should do most, and that strict limits now would slow the growth they need to reduce poverty.
• The costs of acting are immediate and fall on particular industries and voters, while the benefits are long-term and shared with other countries and future generations. Governments are under pressure at home to promise little.
• An agreement binds only the countries that consent to it, so its targets tend to be set at the level that the least willing country will accept.
• Governments change, and a new government can weaken its country's commitments or withdraw from the agreement.

Monitoring and enforcement are the weakest points. Inside a country the government can inspect firms and fine those that break the law. Between countries there is no authority with that power: a country takes part in an agreement because it chooses to, and it can leave. Emissions and catches are reported by the countries themselves and are costly to verify independently. Without reliable monitoring, countries cannot tell whether the others are keeping their promises. Without sanctions, a country that misses its target loses nothing.

Agreements work better when their obligations are specific and can be checked, when breaking them carries a cost such as trade restrictions, when few producers are involved and substitutes exist, and when finance helps lower-income countries to comply. They work worst when they rely on promises that each country sets for itself and that nobody can enforce.

No response removes a welfare loss without cost. The evaluation of any of them rests on three things: how well the externality can be measured, how far the policy changes the quantity, and who gains and who loses.

Measurement. The socially optimum output can be found only if the external cost or benefit is known. Estimating it means putting a money value on things that are not traded: illness and early death, lost species, a changed climate decades from now. It also means identifying who causes the effect and who is harmed, when there may be millions of each.

Policies that work through price, namely taxes and subsidies, depend directly on this estimate. If the external cost is undervalued, the tax is too low and output stays above Qopt. If it is overvalued, the tax is too high and output is pushed below Qopt. Policies that work through quantity, namely permits, quotas and bans, need no price for the harm, but they still need a target quantity, and choosing the target involves the same uncertainty. Governments therefore aim to move the market toward the optimum; they cannot know that they have reached it.

Effectiveness. How far a policy moves the quantity toward Qopt depends on conditions in the market.

• Price elasticity of demand. A tax or a subsidy changes the quantity by more when demand is price elastic, because buyers respond strongly to the change in price. Where demand is price inelastic, the main effect of a tax is revenue, and regulation or education is needed to change the quantity.
• Substitutes. A carbon tax cuts emissions by more where low-carbon energy is available, because buyers have something to switch to. Without substitutes they pay the tax and carry on.
• Time. Demand and technology respond more in the long run than in the short run. A tax that changes little at first becomes more effective as equipment is replaced, and education works only over years.
• Enforcement. Regulations, quotas and permit schemes change behaviour only as far as they are monitored and penalties are applied. A tax collected from a few large suppliers is harder to evade than a rule that has to be checked at thousands of sites.
• What other countries do. If production can move abroad, a national policy reduces output at home without reducing a global externality. The more countries act together, the more effective each country's policy becomes.

Stakeholders. Each response changes the position of consumers, producers, the government and third parties in a different way.

Workers are affected through producers. Jobs are lost in industries that contract, such as coal mining, and created in industries that expand, such as renewable energy, but not necessarily in the same places or for the same people. Future generations are third parties who gain from every policy that protects a common pool resource, and they have no voice in the decision. A policy that is efficient can still be rejected when the groups that lose from it are concentrated and organised while those that gain are scattered, so the stakeholder impact of a policy helps to decide whether it lasts.

• Allocative efficiency is achieved where MSB = MSC. An externality separates a private curve from its social curve, so the market output, where MPB = MPC, differs from the socially optimum output.
• Externalities of production separate MPC and MSC; externalities of consumption separate MPB and MSB. Negative externalities lead to too much output and positive externalities to too little.
• The welfare loss is always the triangle between MSB and MSC that runs from the market output to the optimum output, with its point at the optimum.
• Merit goods are under-consumed because of external benefits, imperfect information and low incomes. Demerit goods are over-consumed because of external costs, imperfect information and addiction.
• Common pool resources are rivalrous and non-excludable. With no price, each user's incentive is to overuse them. The result is the tragedy of the commons: a negative externality that threatens sustainability.
• Taxes and tradable permits put a price on an external cost. Regulation limits behaviour directly. Education shifts demand. Subsidies and government provision raise the quantity of goods with external benefits. Self-governance and international agreements manage shared resources.
• Each response is evaluated by how well the externality can be measured, how far the quantity will change, and who gains and who loses.