Question

Discuss different types of externalities by providing examples and discuss why they can make market outcomes inefficient.

Answer 1

Externalities are characterized as the economic activity's positive or negative effect on unrelated third parties. Since the causers are not directly affected by the externalities, they are not going to take them into consideration. As a result, these activities ' social costs (or benefits) differ from their individual costs (or benefits), resulting in a market failure.
There are various kinds of externalities. The above definition indicates they can either be positive or negative. In addition, there is another (and perhaps less familiar) distinction to be made here: on the output or consumption side, both positive and negative externalities may occur.

Positive Externalities

Beneficial externalities are considered to be economic activities which have positive effects on unrelated third parties. Beneficial externalities of output are positive effects that occur during a good or service production process. An example of this might be an orchard next to a beehive. In this situation, both the farmer and the beekeeper benefit from each other, although in their decision-making from an economic perspective, none of them has taken into account the needs of the other.

Generally speaking, the overall benefit of positive externalities to society is greater than that considered by the actors in their decision-making process. This results in undersupplying goods or services that are beneficial to society. For order to correct these market failures, it is important to know whether the externality occurs from the manufacturing or distribution side as this affects the desired optimal market balance.

Negative externalities

Negative externalities are characterized as economic activities that affect unrelated third parties with negative effects. These can be further divided into negative externalities of output and negative consumption.
Negative externalities of output are adverse effects that occur during a good or service's production process. Pollution caused by firms during the manufacture of their products is the most common example of this kind of externality. Pollution impacts the population as a whole; but, as long as corporations are not held accountable for it, they have no incentive to reduce their economic impact (because it would be more costly).

Negative externalities of consumption are negative effects that occur when a good or service is consumed. We can revisit your neighbor to give you an example. If she likes playing loud music in the middle of the night, sleep deprivation could be a negative externality on your part. Also, as the effects do not directly affect her, she may not take this into account.

Externalities lead to market failure because the price equilibrium of a product or service does not accurately reflect the product or service's true costs and benefits. Equilibrium, which is the perfect equilibrium between the advantages of consumers and the costs of producers, is expected to result in the optimum production level. Nevertheless, when there are major externalities, the equilibrium model becomes skewed, creating incentives that push individual actors to make decisions that ultimately make the group worse off. This is regarded as a failure of the economy.