Externalities Definition

Tejvan Pettinger November 28, 2012

Externalities occur when producing or consuming a good causes an impact on third

parties not directly related to the transaction.

Externalities can either be positive or negative. They can also occur from production or
consumption

Positive Externality in Production.

A farmer grows apple trees. An external benefit is that he provides nectar for a nearby bee keeper
who gains increased honey as a result of the farmers orchard.

Negative Externality in Production

Making furniture by cutting down rainforests in the Amazon leads to negative externalities to
other people. Firstly it harms the indigenous people of the Amazon rainforest. It also leads to
higher global warming as there are less trees to absorb carbon dioxide.

Positive Externality in Consumption.

If you take a three year training course in IT. You gain skills but also other people in the
economy can benefit from your knowledge.

Negative Externality in Consumption

If you smoke in a crowded room, other people have to breathe in your smoke. This is unpleasant
for them and can leave them exposed to health problems associated with smoking.

Market Failure
Definition of Market Failure This occurs when there is an inefficient allocation of
resources in a free market. Market failure can occur due to a variety of reasons,
such as monopoly (higher prices and less output), negative externalities (overconsumed) and public goods (usually not provided in a free market)
Types of market failure:
1. Positive externalities Goods / services which give benefit to a third party,
e.g. less congestion from cycling

2. Negative externalities Goods / services which impose cost on a third party,

e.g. cancer from passive smoking
3. Merit goods People underestimate the benefit of good, e.g. education
4. Demerit goods People underestimate the costs of good, e.g. smoking
5. Public Goods Goods which are non-rival and non-excludable e.g. police,
national defence.
6. Monopoly Power when a firm controls the market and can set higher prices.
7. Inequality unfair distribution of resources in free market
8. Factor Immobility E.g. geographical / occupational immobility
9. Agriculture Agriculture is often subject to market failure due to volatile
prices and externalities.
Key Terms in Market Failure

Externalities: These occur when a third party is affected by the decisions

and actions of others.

Social benefit: is the total benefit to society =

Private Marginal Benefit (PMB) + External Marginal Benefit (XMB)

Social Cost: is the total cost to society =

Private Marginal Cost (PMC) + External Marginal Cost (XMC

Social Efficiency: This occurs when resources are utilised in the most
efficient way. This will occur at an output where social marginal cost (SMC) =
Social Marginal Benefit. (SMB)

Overcoming Market Failure

Tax on Negative Externalities e.g. Petrol tax

Carbon Tax e.g. tax on CO2 emissions

Subsidy on positive externalities why government may subsidies public

transport

Laws and Regulations Simple and effective ways to regulate demerit goods,
like ban on smoking advertising.

Buffer stocks aim to stabilise prices

Government failure why government intervention may not always improve

the situation