Question

Why are externalities referred to as "market failures?" Does the market system actually encourage this behavior? Identify two possible solutions to externalities.

Answer 1

Externalities arise when the activity of an entity directly affects the activities of another entity in a manner that is outside the market mechanism . Externalities can be positive externalities or negative externalities . Externalities exists when all inputs in the production process are not correctly priced . Eg: when a firm dumps garbage into the river , he does not take into account the harmful affects his activities has on the people depending on the river as there are no cost imposed on the firm for using the river . In this case , private cost of production (MPC ) differs from the social cost of production (SPC).

When SPC > MPC , there exists negative externalities so there is over-production of the good than the optimal level .

When SPC < MPC , there exists positive externalities so there is under -production of the good than the optimal level .

Externalities can be corrected in the following manner :

1. imposition of tax in case of a negative externality or providing subsidy incase of positive externality .
2. Merger of the affected parties can lead to internalisation of the problem resulting in optimal level of production .