When free markets do not maximise society’s welfare, they are said to ‘fail’ and policy intervention may be needed to correct them. Many economists have described climate change as an example of a market failure – though in fact a number of distinct market failures have been identified.

The core one is the so-called ‘greenhouse-gas externality’. Greenhouse gas emissions are a side-effect of economically valuable activities.

Most of the impacts of emissions do not fall on those conducting the activities – instead they fall on future generations or people living in developing countries, for example – so those responsible for the emissions do not pay the cost. The adverse effects of greenhouse gases are therefore ‘external’ to the market, which means there is usually only an ethical – rather than an economic – incentive for businesses and consumers to reduce their emissions. As a result, the market fails by over-producing greenhouse gases.

Economists concerned about this market failure argue for policy intervention to increase the price of activities that emit greenhouse gases, thereby providing a clear signal to guide economic decision-making at the same time as stimulating innovation of low-carbon technologies. In order to ensure that emissions cuts are spread out across the economy as inexpensively as possible, economists tend to favour policies that ensure that all businesses and households face the same price on carbon– such as a tax on emissions or an emissions trading scheme.

The greenhouse gas externality is accompanied by a number of other market failures, including those arising from a lack of information about how to reduce emissions, network effects and a lack of innovation incentives. These call for a package of interventions including, but not restricted to, a price on carbon, according to economists concerned about climate change.

For example, new networks are likely to be important in several areas of low-carbon energy supply – such as the ‘smart’ electricity grid and electric vehicle charging points. But such networks can be difficult to establish through market forces alone, because in the early days of a network the benefits may be very limited, despite the potentially huge benefits that can be achieved once the network reaches a critical mass.

Take electric vehicles: they’re inconvenient if charging points are few and far between, but much more useful once a large network of charging points is established. (This is an example of a positive type of externality: when a network increases in size, every member of the network benefits, even though they have not paid for this benefit.) As a result, policy support may sometimes be necessary to help kick-start useful networks.

In the case of innovation, markets currently fail to offer sufficient incentives for the development of low-carbon technologies. An innovative idea that can be copied or used with no financial payment for its inventor may not materialise in the first place, as there is little incentive to invest in developing the idea. Policy interventions such as subsidies for R&D can help to overcome this barrier.
This article was written by Alex Bowen, Simon Dietz and Naomi Hicks and is a reproduction of the following article “Why do economists describe climate change as a market failure?|” ©, 2012, The Guardian, used under a Creative Commons No Derivative Works licence|.

Keep in touch with the Grantham Research Institute at LSE
Sign up to our newsletters and get the latest analysis, research, commentary and details of upcoming events.