Climate Change: The Greatest Market Failure

Why economists describe climate change as a market failure on an unprecedented scale, and what makes it so hard to solve.

In 2006, the British economist Nicholas Stern published a major review for the UK government, The Economics of Climate Change. It described climate change as “the greatest market failure the world has ever seen”.

Why it is a market failure

When people burn coal, oil and gas, they release greenhouse gases, mainly carbon dioxide, that warm the planet. The damage, from heatwaves, floods, droughts, rising seas and crop losses, falls on people everywhere and in the future. Those who emit do not pay for this harm. This is a classic negative externality: a cost imposed on others that is not reflected in prices.

Because fossil fuel prices do not include the climate damage they cause, people use more of them than is best for society.

What makes it especially hard

Climate change differs from local pollution in several ways:

Global: greenhouse gases mix in the atmosphere, so emissions anywhere affect everyone. No single country can solve the problem alone.
Long-lasting: carbon dioxide stays in the atmosphere for centuries, so today’s emissions affect future generations.
Uncertain: the size and timing of damages, and the risk of extreme outcomes, are uncertain.
Unequal: those who contributed least, including poorer countries and future generations, often face the greatest harm.
Free-rider problem: each country benefits from others cutting emissions, but bears the cost of its own cuts, creating incentives to do little.

A global public good

A stable climate is a global public good: everyone benefits from it, and no one can be excluded. Like other public goods, it tends to be underprovided without cooperation.

The shared atmosphere

A factory in one country burns coal to make steel. It earns profits and its customers get steel. The carbon dioxide it releases contributes to rising temperatures that may worsen floods thousands of kilometres away decades later. The people harmed are not part of the transaction and cannot bargain with the factory. This is why economists see climate change as an externality on a global scale.

The economic response

Economists broadly agree on core tools: putting a price on carbon, supporting clean technology research, regulation where prices are hard to apply, and international cooperation, alongside adapting to changes that cannot be avoided. Later lessons explore these ideas.

Thinking climate change is only an environmental issue

Climate change is also an economic problem about prices, incentives, investment, fairness between generations and international cooperation. Economic analysis is central to designing solutions.

Key takeaways

The Stern Review called climate change the greatest market failure the world has seen.
Greenhouse gas emissions are a negative externality not reflected in prices.
Climate change is global, long-lasting, uncertain, unequal and prone to free-riding.
A stable climate is a global public good that needs cooperation.