Question

What are externalities? Why might markets which produce at equilibrium actually over or under produce goods/services? How could the government improve such market outcomes?

Answer 1

Externalities are the

• uncompensated impact of an activity on the well-being of a bystander that neither pays nor receives any compensation for that impact

Markets might end up producing at equilibrium that either overproduce or underproduce goods/services because of the presence of externalities

In the case of positive externalities,

• Markets produce smaller quantity than what is socially desirable ( under - production )

In the case of negative externalities,

• Markets produce a larger quantity than what is socially desirable ( overproduction )

As you can see in Fig (A) in case of Positive Externalities

• Market Output < Optimum Output  and hence markets tend to produce a smaller quantity than what is socially desirable ( under - production )

As you can see in Fig (B) in case of Negative Externalities

• Market Output > Optimum Output and hence markets tend to produce a larger quantity than what is socially desirable ( overproduction )

The government improve such market outcomes by

• Subsidizing goods that have positive externalities to incentivize the producers to produce more and reach the Optimum level
• Taxing goods that have negative externalities to incentivize the producers to produce less and reach the Optimum level