Question

Provide an example of ‘positive’ “externality” and an example of ‘negative’ “externality.” Explain The effect in terms of “market failure” of each example.

Answer 1

Externality:

It includes both external cost and external benefit. In other words, there can be negative or positive externality. In the case of negative externality, action of an economic agent creates cost for others. For example: Smoker causes cost for non smoker.

On the other hand, in the case of positive externality action of an economic agent create benefits for others for which it does not receive anything in return. For example: Beautiful flowers in the garden creates fresh environment for passersby. The term externalities refer to both external cost and external benefit.

In the presence of externalities, market failure arises due to divergence between private and social cost or divergence between private and social benefit. Externality can be consumption externality or it can be production externality.

Market failure refers to failure of competitive market to allocate resources efficiently or distribute goods efficiently. In the case of market failure, pareto optimality conditions are not satisfied. Market failure occurs due to presence of externalities, provision of public good and asymmetric information.