Overlapping Market Failures

When Externalities Offset Each Other

It is common for introductory economics courses to emphasize the virtues of competition and the importance of regulating or taxing negative externalities. For instance, if a power plant emits pollution, standard doctrine teaches that policymakers should tax or otherwise control these emissions to address the harm they impose on society. But reality can be more complicated. When multiple market failures overlap, fixing only one of them might not improve overall welfare. In fact, making one distortion “better” may make the other distortion “worse,” reducing total wellbeing.

This idea has a deep grounding in economic theory, notably in the General Theory of the Second Best, introduced by R.G. Lipsey and Kelvin Lancaster in a seminal 1956 paper. A simple statement of this theory is as follows: if there exist multiple market failures (or distortions), and you cannot correct all of them, then fixing one may make matters worse rather than better. This principle encourages economists to look carefully at how one distortion may offset or interact with another, and to consider how “fixing” one might remove a beneficial counter-balance.

The Monopolist that Imposes an Externality

To illustrate, consider an example that draws from Lipsey and Lancaster’s work. Monopoly is commonly viewed as a market failure: a monopolist charges a price higher than marginal cost and restricts output compared to a competitive market. Negative externality from production is another source of market failure: if the monopolist’s production harms third parties (for instance, through pollution), it may produce “too much” from a societal perspective.

In a simple, textbook world, the correct approach to these problems would be to break up the monopoly or regulate its pricing to produce at a more efficient level. Then tax or regulate the externality to address harm to third parties. But consider the possibility that the monopoly—left unregulated—produces less output than a competitive market would. This can (strangely) help mitigate the externality because the monopolist’s restricted output inherently lowers pollution. Hence, if you only correct the monopolist’s market power by forcing it to produce more, you may worsen the pollution externality. The same is true of taxing the negative externality. Doing so will exacerbate the underproduction problem associated with monopoly.

If you cannot fix both the monopoly problem and the pollution problem perfectly, then solely fixing one can be counterproductive. Leaving the monopoly alone (allowing it to restrict production, thereby resulting in an externality that is not so severe) might be a workable solution. While this is not the ideal scenario that would result from fixing both market failures, it may be a reasonable “second-best” outcome.

Intertemporal Externalities: When Today Affects Tomorrow

The second-best logic also applies to intertemporal settings—where actions today have consequences for the future. Textbooks typically focus on “static” externalities: for example, a power plant polluting the air and causing health problems for local populations. The usual response is to tax the polluter so it accounts for the health costs it imposes. But if there are other distortions in markets, especially those that unfold across generations, a singular focus on “tax the polluter to reduce health problems” might mislead us.

Imagine a power plant that emits air pollution, which raises the risk of mortality among the elderly. The typical story is simple: that’s bad. We want policies that lower pollution to reduce deaths among vulnerable populations.

However, consider another externality lurking in the background. When the elderly live longer, they create a burden for society, because most of the elderly do not work. They rely on pensions, Social Security, or family support. Beyond that, longer lifespans reduce their net bequests left to their descendants. If the elderly consume more resources in retirement (healthcare, living expenses, etc.) because they live longer, that might reduce the amount of wealth transferred forward. This is a “savings externality.”

Paying to Accept More Risk

Why does this matter? Because if people in the future prefer to have more resources (to invest, to consume, to grow the economy and overall wealth), they might—paradoxical as it sounds—want the current generation to accept more risk from pollution. By accepting higher risk in the form of power plant pollution, the present generation can achieve higher lifetime net savings. Future generations receive larger bequests and therefore earn higher future incomes.

If future people could negotiate with today’s society, they might be willing to pay the elderly to accept this higher mortality risk. In a world of frictionless bargaining, they would pay current society to allow more pollution (or equivalently, to reduce environmental regulations) until the net cost from the “savings externality” is fully offset.

Given intergenerational trades along these lines are impossible, the second-best dynamic appears when we realize that the polluter’s emissions wind up being a counterbalance to the negative savings externality the elderly impose on future generations.

When Traditional Policy Conclusions Flip

If the overriding goal is to maximize total wealth (or even total health) in the long run, then more pollution today could generate an overall “better” outcome—especially if that pollution spurs higher future savings, investment, and larger future health budgets. Put more starkly: future people might prefer this generation to accept greater risks, because the resulting higher future wealth can buy more health improvements (or anything else) later on.

Such a conclusion is obviously controversial. It challenges our intuitive moral sense of wanting to protect vulnerable populations here and now. Yet the theory of the second best reminds us that in a world with multiple, overlapping distortions, the “obvious” policy may not always be the globally optimal policy.

Conclusion

The central lesson is not that we must blindly accept more pollution. Rather, it is to recognize the possibility that one market failure can sometimes offset another—and that in such scenarios, focusing on only one externality in isolation can lead to misguided policy. The original Lipsey and Lancaster insight is as relevant now as ever.

The core implications for policy makers are as follows: First, identify all significant distortions in the system—don’t look at just one. Next, understand their interactions. Sometimes they counterbalance each other. Finally, pursue policies that consider the entire set of distortions, aiming for a first-best outcome where possible, or a second-best outcome that may be more welfare-enhancing than a first-best policy in a world assumed to be without overlapping market failures.

It is vital to keep these complexities in mind. Doing so clarifies why many real-world problems do not follow simple textbook logic. Economics, after all, is not just about supply and demand curves, but about navigating a messy world of overlapping incentives, distortions, and externalities—across both space and time.