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Externalities and Market Failure

Updated on April 7, 2016
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IRSHAD CV has been a student in Economics. Now he is doing Masters in Economics. He completed B.A. Economics from the University of Calicut.

People are using goods and services. Most of the commodities create externalities either directly or indirectly.
People are using goods and services. Most of the commodities create externalities either directly or indirectly. | Source


Now, human beings can’t lead life without having certain goods and services. This is the reason why human wants are arising. To fulfill the day to day requirements of the people, they often demand goods and services. To access the commodities, people spend their income in terms of marker determined price. So, the prices of goods and services must be equal to the utility derived from the commodities, even it is difficult to calculate. Generally consumers won’t spend any penny amount on goods and services than its original price or value. Unfortunately, sometimes, market may misguided and some commodities value at higher and some other commodities value at lower price. Such type of over valuation or undervaluation of commodities creates externalities on goods and services.

What is Externality?

Externality refers to the determination of value of a commodity other than the actual market price. Externalities may arise in between producers or consumers. In the case of producers, they are selling commodities, sometimes, they may sell it at comparatively lower price even the commodity has some extra ordinary capacity. Some of the commonly seeing externalities among producers are the dumping of wastages to the environment, creation of pollution and hazardous toxic etc. In this case, the producer will never count the actual value of their output by including the cost on the nature and society during the production process. So there exists externality in the production.

Similarly consumers are also dealing with externalities. For example, healthcare is a service and people are benefiting from it. Suppose a person made checkup on his health condition and following a systemic way of life. It will generate many indirect benefits to his family and the society. Here the actual payment for healthcare services is made by a single patient. But its benefits are indirectly transferred to those who did not make payment. So the price of healthcare service is overvalues for the patient. The reason is, the entire benefit of healthcare spending has not enjoyed by the patient. Take another case, a person is a regular smoker. Here the dangerous effect will also affect the society or the non-consumers. So, there is a hidden cost or social cost on such consumption and it has not considered while determining the price of the commodity. In fact, externality arises out of external costs or external benefits.

Two Types of Externalities

Based on the nature of externalities, it can be classified in to two.

i) Positive externality, and

ii) Negative externality

Positive Externality

An externality can be said to be positive when it generates external benefits to others or to the society. Say for instance, a person made beautiful garden around his home as usual. The person didn’t thought about the benefits of other from his action. He made all the payments for the rehabilitation of the home and building of garden. On the other side, his neighbors began to get more benefits from this work in the form of clean air, beautiful scenery, cool atmosphere etc. So here the commodity (beautification of garden and houses) is totally undervalues and overvalues to the homeowner. The reason is, the person made the payment and the benefits from it are shared to others who did not made payment. Even though, the above mentioned positive externality is good for many individuals, it can’t be justified before the judgment of market. The simple reason is that, the commodity has undervalued.

Negative Externalities

Negative externality is unlike the positives externality, here it generates external costs instead of external benefits. It can be simply understand from the given example. Suppose a manufacturing company started production in a village near by a river. There will be many benefits to the society like employment generation. But there may also generate external costs in the form of sound pollution, water pollution and air pollution. Such external costs may not take in to the account of the company while calculating their cost benefits analysis. So the output of the company and its price will not be actual one.

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Market Failure and Externalities

Market failure is a condition in which the market fails to determine the actual value of goods and service. Market failure often causes due to externalities. It can also said, a condition in which the goods and services are failed to sell at market price by including the value of external benefits and external costs. From the view of market, both negative and positive externalities are not good for the system. Market failure due to externalities would reduce the utility for the ultimate payer or may create some external costs on others. To solve the issue of externalities, many methods can be adopted by the government and the legal system.

Public transportation is a public good. Most of the cases user never makes payment
Public transportation is a public good. Most of the cases user never makes payment | Source

Public Goods and Externalities

Public goods and private goods are the most common goods in any society. Private goods are owned and consumed by private individuals. They are also making its payments. So, the ultimate aim of private consumption will be utility maximization. Thus most of the private goods are consumed at its best way. But when come to the public goods, the condition will be entirely different.

Public goods are generally supplied by government and are jointly consumed. No one can resist the consumption of others. The best example is the public transportation system. Generally, the payment for such services is not paid by its users, instead in most of the cases such goods and services are supplied at the cost of government. Since it promotes free consumption, there will be over consumption. This social behavior towards public goods is the so called free-riders problem. There may happen externalities in different ways like the over consumption or under consumption or damaging of the goods etc.


Externalities are one of the main issues of consumption and production. It generates external benefits or external costs on other people and also leads to the market failure. Market failure can be solved through legislation and governance. Externalities are widely seeing among public goods mainly due to the free-riders problem. In fact, externalities are one of the most important study matters to develop our economic system to function more efficiently.


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      IRSHAD CV 17 months ago from India, Kerala

      Thanks tobusiness for your comments. This topic is one of the most relevant issue of legal system and property right issues etc.

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      Jo Alexis-Hagues 17 months ago from Bedfordshire, U.K

      Interesting article. As an avid gardener, I can relate to this example of negative and positive Externalities. This is not a subject most of us think about as we go about our daily lives, but thought-provoking all the same.