Competitive markets work well, when they do work well, because everything that a buyer or seller needs to know about other buyers and sellers is summarized by the market price. A buyer or a seller does not need to know why a particular price is low: all that he needs to know is that it is low. Knowing only prices, the buyers and sellers make self-interested decisions that lead to desirable outcomes.

Competitive markets do not work well in the presence of externalities because some important information is not summarized by prices. The people who buy the goods produced by a polluting factory only care about the market price of those goods, but the firm's neighbours care about the firm's volume of production and the cleanliness of its technology – information that is not neatly encapsulated in prices.

Alternatively, consider the nightclub to which no one ever goes because no one ever goes. Its location and prices and decor are appealing, but people believe it to be as quiet as a graveyard, so they don't go – making it as quiet as a graveyard. If everyone had expected it to be crowded and noisy and exciting, they would all go, making it just the sort of place that they expected it to be. The nightclub is an example of a participation externality.