An idealized property rights systems has four characteristics:

1. universality: Everything is owned by somebody.  All entitlements are clearly defined.
2. exclusivity: All benefits and costs deriving from property accrue only to the owner, either directly or as rent payments from authorized users of the property.
3. transferability: Property rights are freely transferable between people in voluntary exchanges.
4. enforceability: The owner's property rights are protected from seizure or encroachment.

Unfortunately, real-world property rights systems are incomplete and imperfect, and these result in various market failures.  As we noted earlier, most economists view market failures as the exception rather than the rule.  Here we define six types of market failure that can explain why we have excess pollution:  These are not mutually exclusive categories of market failure; rather, they provide alternative frameworks for understanding various environmental problems.

• externalities
• common property resources
• public goods
• imperfect markets
• diverging social and private rates of discount
• government failure

The social costs of pollution-generating production exceed the private costs of production if they include a marginal pollution damage cost that is external to the firm's accounting framework.  In this graph, a polluting firm produces output a level Q'  where marginal private cost equals demand.  The socially optimal level of output is Q* where marginal social cost (marginal private cost plus marginal pollution damage cost) equals demand.  The socially optimal level of output Q* is less than the private optimum level of output Q', and the social optimum price per unit P* is higher than the private optimum price P'.

If a firm can use the environment for free waste disposal, it generates too much output, sells it too cheaply, and produces too much pollution. In producing too much, it bids other resources away from more efficient uses. Thus pollution externalities can generate market distortions throughout the economy.

"Pecuniary externalities" are only manifested through prices. For example, a large firm moves into an area and bids up land and labor prices, increasing costs for other firms in the area. This is efficient. Pecuniary externalities do not imply market failure, and are not true externalities.

Common property (or "open-access") resources are overused and depleted too quickly because there is no economic incentive to conserve them: whatever you try to conserve, the next person will take. Examples include fisheries, game stocks, subsurface pools of oil owned by multiple companies.  Garrett Hardin's common is overgrazed and destroyed because each herder perceives the added beenfit to himself of adding another animal to his own herd, but doesn't consider how the overgrazing will harm other herders' herds.

A competitive market exploits a common-property resource to the point X_OAwhere the average value product equals the marginal factor cost.  All potential profits (rents) from the resource are dissipated through over-use. In constrast, the efficient, rent-maximizing level of use X* is is where the marginal revenue product equals the marginal factor cost.

Pollution problems arise from overuse of the environment as a common-property or open-access resource.

Public goods are characterized by non-excludable and non-rival consumption: it is impractical to prevent people who haven't paid for it from using or enjoying the good, and one person's use or enjoyment of the good does not use it up or preclude another's use or enjoyment of it.

The aggregate demand for a conventional market good (excludable with "rival" consumption) is constructed as the horizontal aggregation of the individual consumers' demand schedules.

In contrast, the non-excludable, non-rival nature of a public good implies that its aggregate demand schedule is the vertical summation of the individual demand schedules. 

In the diagram to the right, A buys Q' units for herself, and since A cannot keep B from using or enjoying it too, B simply free-rides on the quantity A purchased rather than buying his own.

The social optimum quantity of the public good is Q*, where A and B's collective marginal willingness-to-pay equals MC.

Unfortunately, it will be difficult for A and B to agree on a collective purchase of Q*, since their marginal WTP's for any level of Q are different. In general, public goods are under-supplied unless each user can be induced to contribute his or her marginal WTP. The costs of negotiating such collective purchases are often prohibitive.

Examples of public goods include national defense, scenic landscapes, air and water quality, biological diversity, etc. Note that public goods are not necessarily publicly-owned or publicly provided. Public goods motivate free-rider behavior: the person who wants it the most pays for as much as he or she wants, and everyone else enjoys it for free.

A single polluter may harm thousands of people and keep getting away with it as long as no one person is harmed enough to do something about it.  Everybody would like to see the polluter punished, but since organizing community opposition to the polluter takes time and money, each affected person simply waits for someone else to take the initiative, and nothing gets done.  Community activism is thus an undersupplied public good.

There are several more general categories of market failure:

Imperfect markets involve monopoly distortions that generate shortages and higher prices for monopolized products, a well as underemployment in the input markets the monopolist buys from.  In contrast to a price-taking competitive firm, a monopolist faces a downward-sloping demand schedule, and reduces output below the competitive market level to search for the price that maximizes his profits.   This implies that the monopolist's MR schedule is distinct from his market demand schedule, so that equating MR and MC maximizes monopoly profits.  The monopolist produces and sells less, employs fewer resources, and charges more than a competitive market.  The costs of these economic distortions are termed deadweight loss.

Diverging social and private rates of discount may reflect risk premiums which are higher for individuals than for society as a whole.  Firms exploit open-access resources as if their discount rates were infinite.  The behavior of individuals and firms whose long-term survival is in doubt can reflect very high discount rates  

Government failure involves regulatory distortions of market incentives. There is a whole branch of economics that analyzes the behaviors of special interests in the political process.  Many firms not only compete in the market, but in the political arena as well, making large contributions to politicians to obtain protectionist legislation, tax loopholes, monopolistic advantages, etc.. Most of the public remains "rationally ignorant" of this rent-seeking behavior: since the public costs of special interest provisions are spread across so many taxpayers, it's not personally worthwhile for any individual citizens to oppose them. In effect, citizen action to counter special interests is an undersupplied public good.