Consider two ways of commuting in a crowded city: taking public transportation, such as subway and buses, or driving your own car. A person who chooses to take public transportation in a crowded city imposes a NEGATIVE OR POSITIVE externality on drivers. A policy implication of this result is a SUBSIDY FOR OR TAX ON those who take public transportation. Persons who choose to drive their own cars to get around in a crowded city impose a NEGATIVE OR POSITIVE externality on other drivers. A policy implication of this result is a TAX ON OR SUBSIDY FOR those who drive their own cars.

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Market Failure Analysis

To understand Market failure, we need to first understand welfare economics. An Italian economist, Vilfredo Pareto stated that allocation of resources in an efficient manner such that an economic change, which harms no one and makes someone better off, indicates an increase in social welfare. It is also called Pareto Optimality, where resources cannot further be reallocated without harming one. This does not apply to those economic changes, which harm some and benefit others. social welfare increases if the utility of any of its members' increases and none decrease in the economy.