To understand what market failure is, we first need to look at markets working correctly.

The assumption is that if markets are working freely with no imperfections, this will give the most efficient
outcome, but what does the most efficient outcome actually mean?
Well, if an economy is working efficiently:
1. Firms will be producing at the lowest cost per unit possible (productive efficiency)
2. The economy's resources will be allocated between firms and industries in the most efficient way (allocative
efficiency)
So the economy will be at a point on rather than within its production possibility frontier.
The production possibility frontier (PPF)
A production possibility frontier (PPF) shows all the possible combinations of two mutually exclusive groups
of goods where all the economy's resources are being used and in the most efficient way possible. It is
important that both of those conditions are fulfilled for an economy to be in a situation on rather
than within its PPF.
Suppose our two mutually exclusive groups of goods are 'military goods' and 'non-military goods'.
Point A within the PPF represents a situation where:
1. Not all of the economy's resources are being used
2. Or all resources are being used but not at maximum efficiency
3. Or a bit of both.
Let us assume we are at point A and in the second of the three situations above, with all resources being used
(land, labour and capital), but that our military industries are not presently performing at full efficiency. If this
industry were to become fully efficient, it would be possible to produce more military goods (hopefully as
many as M1M2) without sacrificing any non-military goods. The economy would then move from point A to
point B on the PPF, meaning that the economy would be both productively and allocatively efficient.
Once at point B the economy cannot make more of one type of good without sacrificing the production of
another type of good. If, for example, the economy moved from point B to point C, the economy would make
N1N2 more non-military goods, but at the expense of M2M3military goods. This sacrifice is known as
the opportunity cost.
The main causes of market failure
Once you understand what market failure is, we need to look at the various reasons why markets do fail.
Below are listed the key reasons why markets fail:

Externality

This failure is due to a 'by-product' of a certain production process, or of consuming

something, that affects a third party. This effect can be positive or negative.

The wrong market

structure

This failure is due to the market structure not following the only truly efficient market
structure (i.e. perfect competition)

Public, merit and

demerit goods

This failure occurs as the goods being produced are of a nature that the market would
under provide, over provide or even fail to provide, if the government did not intervene.

Other ways in which There are numerous other reasons why markets fail and these are listed further down in
this topic.
markets fail

An externality is something that is a by-product of a production process but affects a third

party externally (the word from which 'externality' is derived).
The classic example of a negative externality is pollution.
A factory may pump loads of waste chemicals into a river as a result of their production process. This will
negatively affect a third party; fishermen, for example, or a water company who will find it more difficult to
filter the water. The key point is that no compensation is paid. If the factory realised what it was doing, cared
(very unlikely), and paid for the water company's loss, then the problem would be solved.
Below we will look at these issues in more detail using more technical terms.
Private costs, external costs and social costs
With the example of the factory, we need to divide all the costs to society into private costsand external costs.
The social cost of an activity is the total cost of that activity, both privately and externally. So:
Social Cost = Private Costs + External Costs
Let us assume that our factory is making cars. The private costs to the factory owner will include things like
wages, the cost of raw materials and rent. The external cost, or externality, is the cost to the third party of
cleaning up the waste produced by the factory.

The total cost to society, therefore, must include the private cost, because society's resources are being used in
the production process, and the external cost, because some of society's resources must be used to clear up the
mess.
In the diagram above, we have a normal downward sloping demand curve and two upward sloping supply
curves. The lower one, the marginal private cost, represents the car firm's supply curve (remember that the
firm's supply curve is also its marginal cost curve). The other one, the marginal social cost, represents
the true supply curve (and, therefore, the true marginal cost of production) for society as a whole, allowing for
the external cost of production. This external cost is represented by the vertical distance between the two
supply curves (AB).
The car firm does not care about the pollution. The owner is simply interested in maximising profits. The
equilibrium price for him is where demand equals his supply curve, at point B, so output will be Q1 with price
at P1. Given that there is pollution, though, the optimal point for the whole of society is at C, where output is
Q2 and price P2. Hence, if left to the free market, cars will be over-produced at a price, which, in terms of
society, is too low.
The triangle ABC represents the total deadweight loss to society as a result of the firm producing at point B.
All the points within the area ABC are ones where the cost to society (represented by the MSC curve) is higher
than the benefit to society (represented by the demand curve). It is a welfare loss, or a position of allocative
inefficiency.
Pollution is the classic example of a negative externality, but there are others too. Noise is a good example.
Congestion on the roads is also sited. This causes delays for businesses, which costs them money, and also
creates pollution via exhaust fumes.
Private benefits and social benefits
So far we have been talking about negative externalities that arise from the production process - the classic
textbook example. It is possible, though, that negative externalities can arise from consumption. A moment
ago I mentioned congestion as a form of negative externality arising from production. Businesses need to
transport their goods around, most of this is done on the roads and so they cause congestion. But private
individuals cause congestion and pollution when they drive (or 'consume') their private cars.
To illustrate this example, we need to look at private and social benefits:
Social Benefit = Private Benefit + Externality
The reason why the formula uses the term 'externality' rather than 'external benefit' (the formula above had
'external cost') is because this externality can be positive as well as negative. We will look at an example with
a positive externality in a moment.
In the case of people 'consuming' their cars, the social benefit will beless than the private benefit due to the
negative externality of the exhaust fumes.

Look at the diagram above. First, notice that there is only one supply curve which is labelled MSC = MPC. We
are assuming, for simplicity, that there are no negative externalities from the production process, so the
marginal private cost is the same as the marginal social cost.
Secondly, notice that instead of demand curves we have the marginal private benefit (MPB) and marginal
social benefit (MSB) curves. This makes sense. Demand curves, as defined in the topic 'supply and demand',
do effectively measure the private benefit, at the margin, of consuming a certain amount of a good. If the
demand for Mars Bars in a newsagents is 100 per day at a price of 30p (as read off a demand curve) then one
assumes that those 100 consumers felt that the chocolate bar would give them around 30p worth of benefit.
So, the equilibrium in the diagram is a point D, where the supply curve (MSC = MPC) equals the demand
curve (MPB). But this is not the socially optimal position. The MSB curve is below the MPB curve to
represent the negative eternality of private driving. The best equilibrium for society, therefore, is at point E
where MSC = MSB. Hence, again, too many cars are produced and the deadweight loss triangle is DEF (the
area where MSC is greater than MSB).
Positive externalities
As stated earlier, although it is less obvious, there are examples of positive externalities. A good example is
education. This includes training by firms as well as what goes on in schools and universities. If you get a good
education, there are obvious private benefits; better career prospects and higher future earnings for instance.
But there are external benefits as well. The obvious economic one is that a better-educated workforce is a more
productive and efficient one, but there is also the fact that well educated people are less likely to resort to
crime. This is almost like an avoidance of a negative externality.
The diagram above illustrates the education example. The 'price of education' axis is a bit debatable, given that
the majority of school children go to state schools. Assume that there is no state education for the purpose of
this example.
In the diagram, the MSC = MPC curve and the MPB curve are only showed. This is the initial equilibrium
where the quantity and price of education reflects only individuals' private benefit. Spend a little time working
out what should happen to this diagram given the positive externality.
Notice that there is a deadweight loss again (GHJ). This occurs because the amount of education consumed
when only private interests are taken into account (Q5) is less than the socially optimal amount when one
allows for the external benefit to society (Q6). It is the area where MSB > MSC. It is because education is a
'good thing' that the government do subsidise it and makes sure that all children go to school, free at the point
of use, until the age of 16.
The fact that marginal social benefit is greater than marginal social cost might sound like a good thing, but it is
still inefficient because it means more resources should be devoted to this area. It means that the MSC > MSB
in a different market, which is a bad thing as well. A totally efficient economy would have MSB = MSC
in all markets.

Whether the externality is negative, in which case too much of the good in question is produced and
consumed, or positive, so too little is produced and consumed, the problem is the same. When both consumers
and producers strive to maximise their own utility in the free market, the result is an inefficient allocation of
society's resources.
If there is no incentive for either consumers or producers to solve the problems associated with externalities
then it is the job of the government to intervene. Here are some of the options open to the government.
Taxing the polluters
The classic textbook solution to the problem of negative externalities (especially with pollution) is to use
taxation.
Remember that imposing a tax on a good causes its supply curve to shift to the left, ceteris paribus, because it
causes the costs of the producer to rise. Although the producer may pass on some, or all, of the tax on to the
consumer through higher prices (depending on the elasticity of the demand curve), it is the producer who
actually pays the tax bill.
The size of the negative externality, or external cost, is the difference between the marginal social cost curve
and the marginal private cost curve. If the government can correctly assess the true external cost then it can set
the tax at exactly that level, so that the marginal private cost curve shifts until it superimposes itself on to the
marginal social cost curve. This would mean that the equilibrium price and quantity reached by consumers and
producers would now be the same as the socially optimal equilibrium.
The diagram below is a reproduction of the first diagram in the 'externalities' section. As the government
imposes taxes, the MPC curve will slowly shift. This makes the welfare loss triangle shrink, and it is totally
eliminated once the MPC line shifts to the same position as the MSC line.

Some textbooks use the term internalising the externalities to explain what is going on here. By imposing a
tax, the government is forcing consumers and producers to allow for the externality when they make their
decisions. The 'internalising' part of the phrase means 'bringing the externality into the market mechanism',
rather than keeping it external where it difficult to cope with it.
The major problem with this solution is that it is very difficult for the government to work out exactly what the
size of the externality is. If they under-estimate its size, the MPC curve will shift to the left but not quite reach
the MSC curve. Production will still be too high and the price too low. If they over-estimate its size, the MPC
will shift pass the MSC curve on the left, pushing prices up higher than they should be and causing output to
fall below the optimal level.
Other problems include higher prices for consumers (especially for goods like petrol, where demand is
very inelastic), which reduces their consumer surplus. But some would say that, in the case of petrol for
example, cars are big polluters so the ever increasing price of petrol is only now beginning to reflect the
external cost of using cars. It is still cheaper to travel from, say, London to Manchester by car as long as three
or four people share one car, compared with buying separate return rail tickets.
The use of subsidies
Taxes shift firms' supply curve to the left, forcing them, via the market mechanism, to reduce output and
increase the price to reflect the external cost. But what if the good in question has external benefits?
If you remember from above, education is an example of a good that has huge external benefits for society, so
if it were left to the free market, output (which in this case means the number of people educated) would be
lower than the socially optimal level.
In an effort to increase the output of these type of goods, the government can pay subsidiesto the producers.
This will cause the supply curve to shift to the right resulting in a higher output and lower prices. In fact,
education in this country is free for all children up to the age of 16. The subsidy is so big that the price is zero
at the point of use.
Government regulation
Although in an ideal world the solution of 'internalising the externalities', which uses the market mechanism,
would be perfect, in the real world, as we have discussed, it is difficult to get the tax level right. In some
situations the government feels that their intervention needs to be a little more direct.
Instead of taxing pollution, why not just ban it? Or at least legislate to control pollution levels. For example,
cars now have to do an emissions test when they go in for their MOT.
This all seems very straight forward, but similar problems arise. How severe should the legislation be? If a
piece of legislation causes 50 million worth of benefit in terms of reduced pollution, but it cost 60 million to
administer (the cost of fixing anti-pollution filters, for example), then the regulation has been a bit over the top.
As you can see, again it is difficult for the government to get the balance right

Perfect Competition and Monopoly

As we said earlier, the only truly efficient market structure is that of perfect competition. Unfortunately, this
is a fairly unrealistic theoretical model. Very few markets in the world areperfectly competitive, although
many are very competitive. Theoretically, market failure occurs if a market does not have a perfectly
competitive market structure.
Monopoly is the antithesis of perfect competition. It is the least competitive market structure, with
only one firm in the industry. The following diagram sums up why the market fails when there is a lack of
competition in a given industry. You may need to look at the topics of 'Costs and revenues' and 'Market
structure' if you do not remember where these curves come from.
The diagram shows the situation faced by a monopolist. The monopolist maximises profit where marginal cost
equals marginal revenue (MC = MR). This gives a price of Pm and quantity Qm. Its profit is represented by the
shaded box, which is the difference between total revenue (OPmEQm) and total cost (OFDQm). Remember that,
because this is the only firm in the industry, this diagram represents the whole industry. So if this industry was
perfectly competitive, the equilibrium would occur at point B, where the demand and supply curves cross (AR
= MC). This gives a price of Ppc and a quantity of Qpc.
Notice that the lack of competition in monopoly means that the price is higher and quantity supplied/demanded
is lower than under perfectly competitive circumstances. More importantly, the monopolist is not producing at
a level of output that is either allocatively efficient (which occurs at point B, where price =
MC) or productively efficient (which occurs at point A, the minimum point of the AC curve). Under
monopoly, the market fails in that it is not efficient using any measure.
You may be asking yourself, "how come the perfectly competitive equilibrium is allocatively efficient (point
B) but not productively efficient (point C) given that perfectly competitive firms are meant to be fully
efficient?" Remember, this diagram represents the whole industry. Each of the numerous firms in perfect
competition will be both allocatively and productively efficient in the long run (see the topic on 'Market
structure' for detail).
We can apply this analysis to a simpler supply and demand diagram which might be easier to understand.
Again, the perfectly competitive equilibrium occurs where supply equals demand (point C), price Ppc and
quantity Qpc. As we saw in the first diagram, the monopolist raises the price (Pm) resulting in reduced quantity
(Qm) so as to maximise his profits. This diagram shows the loss to society as a result of monopoly in terms
of consumer surplus and producer surplus.
Consumer and Producer Surplus
Consumer surplus falls from ACPpc to ABPm as a result of the price rise. Some of this loss is transferred into
producer surplus, or monopoly profit (PmBFPpc). But the triangle BCF is a dead-weight loss. Triangle CDF is
also lost. This represents profit, or producer surplus, that would have been earned at the higher level of output,
Qpc, but is no longer available because the monopolist has restricted the level of output. So the overall loss to
society is the larger shaded triangle BCD.

The diagrams above show how monopoly, as a market structure, is a form of market failure. The monopolist is
neither allocatively nor productively efficient. There are a couple of points to note. First, it should be
remembered that monopolists can usually take advantage of hugeeconomies of scale. This can cause large
reductions in their average costs that may offset the damaging effects of profit maximisation. Secondly, it
should be noted that all market structures that are, in some way, imperfect will not be totally efficient. The
monopolist takes the biscuit, obviously, but oligopolists face relatively little competition, and may even
collude, causing inefficiency.
Public goods
The first point to note is that public goods are not called public goods because they are provided by the public
sector (i.e. the government). Although they do tend to be provided by the public sector, this is not the reason
for the name!
All public goods have two important characteristics: Non-excludability and Non-diminishability.
Non-excludability & Non-diminishability
Non-excludability. A public good is one where it is impossible to exclude anyone from consuming it. I
suppose this is why they are called public goods - they are open to the public!
Non-diminishability. Some textbooks call this one non-rivalry. I prefer the former because its title explains
what the definition is all about more clearly. If, say, ten people are consuming a certain public good. The
arrival of an eleventh person (who cannot be excluded) will notdiminish the amount that the existing ten
people can consume.
This all sounds a little confusing until we look at some examples. The best one is defence. Whether you like it
or not, as a citizen of the UK you are defended by the army, the air force, the navy, etc. Even if you go on a
CND march, you cannot exclude yourself from being defended. Equally, if the UK experiences a period of net
immigration, the new entrants will be defended, and their arrival does not diminish the amount by which you
are being defended. You are either defended or not defended. You cannot be half defended!
The key point about public goods is that they are 'good' things, so theyneed to be provided, but because of
these two characteristics, they have to be provided centrally, by the government.
Imagine that the government did not provide an army, navy, air force, etc. A private company might have the
idea of forming a national army and to raise the required money, they decide to ask everyone for 10. If you
were that person on the CND march, and you did not want to be defended, then you would not pay. There may
be a lot of people who refuse to pay for this reason. Also, there may be some people who do quite want to be
defended, but take the risk of not paying on the assumption that there will be some people in the UK that will
care enough to pay the inevitable increased price. This is the free-rider problem. The people who do not pay,
for whatever reason, are having a free ride.

Anyway, this private company finds that their predicted revenues are not nearly enough to afford a full defence
system, so they give up. The government can provide these goods because they can force people to pay
through taxation and raise enough money to do the job properly.
Another good example is street lighting. One cannot stop anyone from benefiting from a street light. Equally,
the benefit that one person receives does not diminish the benefit of others. Again, if a private company tried to
finance a set of street lights down a given road by knocking on the doors of the inhabitants of the street, lots of
people would not pay relying on someone who cares enough to fork out for the amenity. So, again,
governments (normally via local government) must provide street lighting.
To sum up, the reason why public goods come under the topic 'Market failure' is that the free market would
fail, horribly, to provide defence and street lighting if left to themselves. The government has to intervene to
correct this market failure.
Merit and demerit goods

Merit goods
Merit goods are also things that are 'good' for you, but unlike public goods they can be provided privately.
The problem is that if they are provided solely by the private sector then they tend to be under-consumed, so,
again, the government has to step in to correct the market failure.
The best two examples are health and education. Both of these goods can be provided privately. Some of you
may be at a private school (or independent school, as they are called), or your family may have a private health
insurance scheme. But, if the government did notstep in and provide state schools and the NHS, then
numerous families would not be able to afford either. This would cause increased crime and reduced
productivity from an underclass of the non-educated, and increased health problems which can also cause
problems for the labour market.
There may also be another section of people who can afford to pay for, say, health insurance, but just feel that
it is a waste of money. They are young, fit and healthy - why bother? Of course, if they get knocked down by a
bus they need the cover pretty quickly, but it is too late. Also, if they have survived the bus and feel they need
cover as they get older, they may find that the premiums are higher than they would otherwise have been, or
they are not covered for various ailments they have picked up on the way (like a bad back, for example).
In other words, people find it difficult to think long term. A 30 a month premium may seem a lot when you're
young and healthy, but it will save you a lot of money over the long term.
Pensions are another example. Although the UK is moving towards a system where everyone has to think of
putting something away privately, many people don't start until they are in their 40s, and this is often too late.
The earlier you start, the longer your initial premiums have to grow with the stockmarket. So, because
'pensions' tend to be under-consumed, the government steps in and provides the state pension.

This pension, though, is becoming smaller and smaller in real terms. Twenty years ago, the government of the
day changed the way the state pension was indexed. Instead of increasing it each year by the rise in average
earnings,it started to link the pension to the inflation rate. Although technically this means the pension is
maintaining its real value, average earnings nearly always rise faster that the price level, so pensioners'
incomes have fallen back relative to workers. This effect gets worse every year. In 2000 the government got a
lot of stick for raising the pension by only 75p.
The government provides health and education free at the point of use, but the general public does pay for
them via taxation. Also, in the case of education, it is seen as so socially desirable that the government
legislates to force all children to attend up to the age of 16.

Demerit goods
Merit goods are 'good' for you. Demerit goods are thought to be 'bad' for you. Examples are alcohol, cigarettes
and various drugs.
In this case the market fails because these goods are over-consumed if left to the free market. Again, the
government must step in to stop this over-consumption. In the case of alcohol and cigarettes, the government
imposes quite heavy taxes and duties. This means that their price rises significantly in the hope that this will
deter people from consumption. But given that both goods have very inelastic demand curves, the fall in
demand is small relative to the tax rise. One wonders if the government keeps raising these taxes because they
care about our health or whether it's just a good source of tax revenue!
Some demerit goods are seen as so destructive that the government bans them altogether, illegal drugs being
the obvious example.
It is important to note that, just as merit goods provided positive externalities that the government wanted to
encourage, demerit goods cause large negative externalities that the government are keen to avoid. The
additional costs of demerit goods are there for all to see: an increased burden on the NHS, increased crime and
the fact that labour productivity is affected in a negative way, which is bad for the economy as a whole.

OTHER REASONS WHY MARKETS FAIL

There are other ways in which markets fail.
Information problems. We said earlier that the only truly efficient market structure is perfect competition. One
of the key assumptions with this market structure is that all buyers and sellers have perfect information. In the
real world, this obviously does not happen. A given restaurant may be half empty one evening and then have
queues down the street the next. Ideally, they would like to be able to adjust their prices to allow for this, but
they do not have the information beforehand to be able to do this (of course, there would be menu costs as
well).
General instability. We see this in stock markets, currency markets and, in particular, agricultural markets.
The price of agricultural products can vary enormously depending on the size of the harvest. A good harvest
can be bad for the farmer because the reduced price (caused by the shift to the right of the supply curve - see
the 'supply and demand' topic) will reduce his revenues. A bad harvest will raise the price, but the farmer
might have very little to sell. Governments often step-in to correct this market failure. They can buy excess
stock when the harvest is plentiful and sell their excesses when harvests are poor so as to keep the price at a
reasonable level at all times. This is called a Buffer stock scheme. The Common Agricultural Policy (CAP)
does this to a certain extent.
Inequality. This one is a little bit obscure. 'Inequality' refers to inequality in the whole economy. For various
reasons, some members of society have more money than they need, whereas other struggle to afford even
basic necessities. Certainly the shift from direct taxation (e.g. income taxes) to indirect taxation (e.g. VAT)
during the early Thatcher years caused the distribution of income in the UK to become more unequal. This
inequality, which was caused in the first place by the market economy (great for those who succeed; a
nightmare for those that don't), is an example of where the 'market' fails, and governments should intervene to
correct this market failure. Labour governments are traditionally more likely to tax the rich and redistribute to
the poor via benefits. This has happened to a certain extent with the Blair government, but not by as much as
many 'Old' Labour activists would like.
Factor immobility. Factor here refers to factors of production. In particular, we mean the immobility of land,
labour and capital. Obviously land is immobile, but in this context we mean whether it is easy or difficult to
transfer the factor in question to another use.
'Capital' generally is fairly mobile nowadays, especially between countries as the old restrictions have been
eliminated. But once money has been invested in a certain type of capital, like a nuclear reactor, how easy is it
to transfer that capital to another use?
The biggest problem in most countries is that of labour immobility. Those of you doing Geography have
probably heard of the terms occupational mobility and geographical mobility.
If someone loses their job, especially in one of the traditional industries like coal mining where there is not
much prospect of regaining employment in the same field, then the worker has two options. He can retrain to
gain different skills and become employable (becoming more occupationally mobile), or move to an area
where one's current skills are still applicable (being geographically mobile).

With a coal miner, there are few areas to which he can move and continue mining. His only option might be to
retrain, and governments again have a role in correcting this market failure by providing this training and then,
perhaps, providing the jobs (as with the New Deal).
A well-qualified lawyer may have difficulty in finding a job in London and so looks to an alternative city. This
is easy enough because house prices and rents are lower outside London than within. But those coming to
London from outside to seek their fortune (like Dick Whittington!) find it almost impossible to find affordable
accommodation, especially if they have a family. The government try to correct this market failure in the
housing market through building new homes, housing associations and more recently, offering assistance with
mortgages for those in respected, but relatively lowly paid, jobs such as teaching and nursing in London. A
nurse has absolutely no chance of buying a house with a mortgage in London, and yet there is a huge demand
for nurses in the capital.
Property rights and permits
These two mini topics are at the end of this section because they are slightly different in that the explanation is
more descriptive rather than diagrammatical. They are also less 'traditional' examples of market failure, and yet
are becoming more and more popular with examiners.

The extension of property rights

Your parents probably own a home. Legal ownership confers certain rights on that owner. If a drunk-driver
flies over the pavement and in to your front garden wall, your parents would probably be able to claim some
compensation from the person who ruined part of their property. In this example the case is clear because it is
also clear who has the property rights.
Markets can fail if these property rights are not fully extended. An example that examiners like to use is that of
the fishing industry. Nobody owns the sea. Fisherman go out to sea and catch as many fish as they can,
considering short term profits rather than the long term viability of the industry. This over-fishing is an
example of market failure. If all fisherman continue to over-fish, then the fish population will not be able to
maintain its numbers through reproduction. The industry will eventually die.

The fisherman know of the problem, but there is no incentive to do anything about it. If one fisherman decides
to have a week off to 'give the fish a chance', all the other fisherman will keep trying to catch as many fish as
possible, so what's the point of thinking of the future?
The solution is to extend property rights. If certain fisherman owned certain areas of the sea, and therefore
had legal rights over them, then they would each have control over a certain area and could stop people from
fishing in their area (or fine them if they do). They could then think about the future and only fish at certain
times of the year, perhaps.
This is another example of internalising the externality. The externality has been brought back into the
framework of the market mechanism. The market price of fish should now reflect the true supply of fish in the
sea rather that the exaggerated supply that occurred with over-fishing.
Or course, there are problems. How do governments extend these property rights fairly? How are they
extended at all given that the things over which rights need to be extended, the sea and the atmosphere,
cross international boundaries? International bodies such as the European Union do have the power to
divide the seas around Europe amongst the various member states, but it is not an easy job. They often resort to
the easier measure of fishing quotas.

Pollution permits
Another more recent solution to the international problem of pollution is to issue permitswhich only allow
each country world-wide a certain amount of emissions of, say, greenhouse gases. The Kyoto Protocol,
launched in 1997, was designed to force all countries to reduce their emissions of greenhouse gases. The sum
of all the permits issued allows for a significant fall in world-wide emissions. Some countries will be better at
reducing emissions than others. If the countries that are good at reducing emissions manage to keep their
emissions below the level allowed by their permits, then they can sell their spare permits to countries that
struggle to keep their emissions down.
The key point is that the total level of emissions allowed world-wide is fixed by the sum of the permits, so
emissions should fall. But this system is better than simply having 'targets' for lower pollution because the
'cleaner' countries have an incentive to reduce their emissions by more than they need to so that they can sell
their spare permits and make some money.
In addition, the countries that have to buy the spare permits because they struggle to keep their emissions down
will probably also have lower costs. The cost of purchasing the expensive equipment required to reduce
emissions is probably higher than the cost of simply buying the extra permits.
Since the Kyoto Protocol was launched, the country that has found it hardest to keep their emissions down has
been the USA (surprise surprise!). By the summer of 2000, they were desperately trying to find a country who
would sell them some spare permits!