Question

Briefly explain why externalities result in inefficient outcomes.

Answer 1

Ans. Externalities are the effect of decision of one person on the other. There can be a positive externality and negative externalities.

If there is a positive externality, like benefits from college education of a person, then the marginal benefits to the society exceeds the marginal private benefits, so, when a person makes a decision he compares the marginal private benefit with the marginal cost, thus, equilibrium output is less than what it would have been if marginal social benefit has been considered. So, the equilibrium output was less than the social optimum that is the equilibrium output was socially inefficient.

If there is a negative externality, like pollution, the marginal social cost exceeds the marginal private cost and the decision is made by comparing the marginal private cost with the marginal benefit. So, the equilibrium output will be more than what is desirable in the society. So, if there is a negative externality then the output produced is socially inefficient.

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