Question

Why the market tends to fail when dealing with environmental issues?

Answer 1

A market is efficient and at equilibrium when there is a free flow of information. That is the primary criteria. However, in the case of environmental economics, there is no tangible information or value available at all times. So when all costs and benefits of a transaction are not limited to the parties involved in the transaction but also depends on some other third party, there is an externality which may be positive or negative. The market usually undervalues goods which have a positive externality.

Let us consider a shared room between 3 people all of whom value a clean apartment. However, no one is willing to clean it. Finally the one who does is not compensated for taking the extra effort. Thus the actual value of cleaning the apartment is not identified and paid for. So the apartment will be more often dirty than clean even though it is socially optimal to have a clean apartment.

Thus we can see with the above example of how the market fails in case of environmental economics. If there was a price of cleaning the apartment and value of appreciating a clean apartment, there would have been an efficient market outcome. However, because of the intangibility and lack of information regarding the values of the action and the result, the market is not efficient and thus it fails.

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