What are externalities?
Externalities occur when an unrelated third party is affected by another person's economic decisions. Externalities can be either on the consumption or production side and have both positive or negative effects.
If externalities are produced by a firm or a company, it is a positive or negative production externality. For instance, if firms pollute a river as a result of its production process, it is known as a negative production externality.
Comparatively, if the externality is caused by consumers, then it is known as a positive or negative consumption externality. For instance, if consumers adversely impact the healthcare system as a result of smoking, this is known as a negative consumption externality.
Externalities demonstrate either an over or underproduction of goods. Therefore, there is a misallocation of resources meaning that the price is not set at the equilibrium point. This incorrect price reduces total welfare as well as creates deadweight loss, therefore, causing market failure.
Furthermore, externalities represent the consumption and production of both merit and demerit goods. Merit goods are described as products that are beneficial for society however, they are usually underproduced, under-consumed and over-priced. Similarly, demerit goods are products that negatively impact society, however, are over-produced, over-consumed and under-priced. This may help better explain why even positive externalities are examples of market failure as they represent the production or consumption of merit goods.