What Is an Externality? Explain the Effects That Externalities Have on the Efficiency of Markets. How Might Externalities Be Corrected?

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When a private action has side effects that affect other people in important ways, we have the problem of externalities. In the absence of any distortions, competitive equilibrium is efficient. Distortions prevent the ‘invisible hand’ from allocating resources efficiently. Externalities are one of these distortions that lead to market failure. The problem arises because there is no market for things like noise. Hence markets and prices cannot ensure that the marginal benefit you get from making a noise equals the marginal cost of that noise to other people. An externality is a cost or benefit arising from an economic transaction that affects a third party and that is not taken into account by those who undertake the transaction. In a market economy this generally means that an externality occurs where there is a direct effect of the actions of one person or firm on the welfare of another person or firm in a way which is not transmitted by market prices. Externalities may take two forms. Firstly there are positive externalities. Positive externalities exist when the marginal social benefit of production and or consumption exceeds the marginal private benefit i.e. production and/or consumption generate external benefits that may go under-valued by the market. An example of a positive externality might be that immunization prevents an individual from getting a disease, but has the positive effect of the individual not being able to spread the disease to others. A negative externality occurs where consumption or production of a good generates a cost borne by someone outside of the production or consumption of that good. A common example of a negative externality is pollution. For example, a steel manufacturing plant might pump pollutants into the air. While the firm pays its private costs such as electricity, gas, minerals etc. The people living around the factory will pay for the pollution since it will cause them to have higher medical expenses, poorer quality of...
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