This study aims to explain how legislation causes market failure by creating problems of externality in forest management in Turkey. In general, legislation is protective and regulatory, but in some cases it could be used in contradictory ways. This study investigates only timber sales to forest villagers and related subsidies concerning market failures and externalities. Subsidized timber sales to forest villagers cause an unfair competition for forest industries. This creates externalities arguable for 'state' and different stakeholders as negative or positive. As an introduction, general overview of market failure, externality and timber sales are summarized. Then, general characteristics of Turkish forestry and the legal reasons for subsidies were explained. Following that, structural differences between Turkish timber market and stochastic free market were summarized and illustrated. After that, materials and methodology of the research were explained. Then, this study was completed by giving results, detailed discussions and conclusions. Depending on computational assumptions, total economic loss in timber sales to forest villagers was computed to about 100 million USD annually. This amounts to approximately ten percent of the total economic value as computed by Turker et al. (2005) which is not negligible. Market structure in timber sales cannot be defined by considering only free market assumptions. Legislation should always be considered by forest managers. The outcomes of this analysis showed that externalities coexisted with legislative provisions.