Why might the free market underprovide positive externalities?

The free market may underprovide positive externalities because it does not account for their societal benefits in pricing mechanisms.

In a free market economy, goods and services are priced based on supply and demand dynamics. However, this mechanism often fails to account for the full societal benefits of certain goods or services, known as positive externalities. These are benefits that are enjoyed by third parties who did not directly participate in the transaction. Because these benefits are not reflected in the market price, the quantity of goods or services produced and consumed may be less than the socially optimal level.

For instance, consider the case of education. The benefits of an individual receiving an education extend beyond the individual to society as a whole. An educated populace can lead to a more productive workforce, lower crime rates, and increased civic participation. However, these societal benefits are not reflected in the tuition fees that an individual pays for their education. As a result, the market may underprovide education because the price does not fully reflect its societal value.

Similarly, consider the production of clean energy. The benefits of clean energy, such as reduced pollution and improved public health, are enjoyed by society as a whole. However, these benefits are not reflected in the market price of clean energy. Consequently, the market may underprovide clean energy because the price does not fully capture its societal value.

In both these examples, the market fails to provide the socially optimal quantity of a good or service because the price does not reflect the full societal benefits. This is known as a market failure. To correct this, governments often intervene by providing subsidies or implementing regulations to encourage the production and consumption of goods and services with positive externalities.

In conclusion, the free market may underprovide positive externalities because the pricing mechanism does not account for their societal benefits. This can lead to a market failure, where the quantity of goods or services produced and consumed is less than the socially optimal level.