Markets allegedly fail because a social cost such as pollution or congestion is imposed on persons and not on those who buy or rent the product. But by the universal ethic, pollution which invades the property of others is an act which is morally wrong and outside the market. The pollution of other people's property is a trespass which, in a free market, requires compensation. This compensation internalizes the cost, eliminating the externality.
The optimal amount of pollution is not zero, but that amount for which the marginal cost of eliminating pollution equals the marginal benefit of less pollution. Normally, the cost of reducing more pollution rises as more pollution is reduced, and the social benefit of eliminating more pollution declines with greater reduction. When polluters compensate others for the damage, then the optimal amount of pollution will tend to take place, as a polluter will weigh the cost of compensation with the cost of pollution reduction. If the transaction costs are low, the affected parties can negotiate an efficient outcome. If there are too many persons affected for negotiations to be effective, then government, acting as an agent for the people, can levy a pollution charge equal, so far as can be measured, to the social cost. Such a charge does not correct a market failure, but rather enhances the market by preventing trespass. Excessive pollution is therefore not a market failure, but a government failure, the failure by government to enforce the property rights of the victims of pollution.
The same analysis applies to congestion externalities. If a large store opens in a neighborhood and there is increased traffic and more congestion, the market has not failed. If the streets were privately owned, the owners would see a profit opportunity and charge higher tolls. If the streets are owned by the government, then congestion implies a failure to charge a toll sufficient to eliminate the congestion. In a congested highway or street, each car imposes a negative externality on the other drivers by increasing the crowding. A toll just high enough to eliminate the congestion is therefore like a pollution charge, and prevents rather than corrects an externality. If a private owner of a highway fails to apply a congestion charge, this is an entrepreneurial failure, since there is no systemic reason to not apply the charge.
The claim of mainstream economic thought that markets fail is not justified. The failures ascribed to externalities, public goods, market structures, asymmetries, injustice, and lack of sustainability, are due to misunderstanding or ignorance of the ethics, governance, and economics of markets. There is plenty of entrepreneurial and human failure, but no inherent systemic market failure.
Free markets never fail.
