Externalities

Good Essays
Market Failure externalities

Objectives of lesson:

• Students should be able to:
1) explain what are externalities
2) understand the various terminologies related to externalities
3) be able to distinguish between negative and positive externality
4) be able to identify the private optimum and social optimum level of output.

Market Failure
• What is market failure?
- is the failure of markets to achieve the optimum resource allocation.
- may be seen to exist in various forms:

• Reasons for market failure:
- existence of externalities
- provision of public goods
- provision of merit & demerit goods
- imperfect markets

Market Failure
• Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption.

• Externalities are referred to as third party or spillover effects arising from production or consumption of a good or service for which no appropriate compensation is paid
(affecting persons not directly involved in the transactions).

What are externalities?

• generated and received outside the market
• Externalities results in a divergence between private and social costs and benefits

• costs or benefits of production or consumption

experienced by society but not by producers or consumers themselves

• arise whenever other people are affected beneficially – external benefits

• arise whenever other people are affected adversely – external costs

Externalities – related terminologies

• Private Cost- directly incurred by individual


producers or consumers when they engage in an economic activity.
External Cost- costs experienced by a 3rd party e.g someone not directly involved in any transaction i.e. it is the cost of an economic decision to a third party

• Social Cost = Private cost + External cost
• Marginal Social Cost = marginal private cost + marginal external cost

Externalities –

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