Question

Discuss how a negative externality prevents a competitive market from allocating resources efficiently. Please explain as simply as you can and try to avoid jargon

Answer 1

Ans. An externality is the effect of decision of one person on the welbeing of the pther person which is not directly related to that decision.

A negative externality is when decision of a person has a negative impact on the well being of the person who is not involved in that decision directly.

For example, pollution from the indistry. This pollution acts as a negative externality for the other people. So, the cost of production assumed by the industry called private cost is less than what society actually incurs (in the form of pollution) called the social cost. The industrialist takes any decision of production by comparing the private cost and the benefit he recieves from product. So, this leads to overproduction. This is because he does not take into account the cost to the society while doing cost benefit analysis. Thus, producing a socially inefficient output.

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