Externalities are the side effects of an economic transaction on third parties who are otherwise not involved in the economic transaction.

Externalities do not just exist in a vacuum. It may occur because individuals choose to consume something that has external benefits or costs to others or because individuals choose to produce something that has external benefits or costs for others.

The main problem created by externalities is that an inappropriate amount of goods and services will be produced and consumed in the free market. Hence there will be an inefficient use of resources.

To understand why this is so, consider a firm that produces chemicals. 

The cost of the firm will include raw material cost, labor cost, energy cost. The above costs are called private costs in that they are directly paid by the firm.

These costs, however, represent a part of the social cost. They are likely additional costs that may be associated with this economic activity.

This might include the costs of air and water pollution generated by the activities of the chemical firm which in turn creates clean-up costs for a third party.

Because the firm does not pay for these costs and does not include them in the price of chemicals, they are said to be external to the firm and are, therefore, called external costs.

This creates a big problem because only private costs that will be incurred by the firm will be considered when making production decisions. External costs are not taken into account by the firm.

What this means is that more goods would be produced than if the external cost has been considered. This situation is represented below.

The supply curve S represents the private cost of producing chemicals. At this market setting, the equilibrium is $E_1$  and the market output was $Q_1$.

Assuming the firm considered all the social costs(private cost plus external cost) of producing chemicals, it would be produced at $E_2$ and a much lower quantity of $Q_2$, which represents the socially optimum quantity.

But, since the firm only took accounts of its private cost, the firm will be producing at $Q_1$ which is larger than the socially optimum quantity of $Q_2$.

Hence, the market fails because the firm is over-producing chemicals with negative externalities.

The reverse is the case for goods with positive externalities. Goods are said to have positive externalities if it has a beneficial side effect on the third party. 

Hence, it is represented via a demand curve. This is because the demand curve represents the benefits consumers derived from goods as measured by the prices they are willing to pay

The problem with positive externalities is that society tends to underproduce goods with positive externalities.

The reason is that the provider of such goods with positive externalities tends to consider only the private benefits. They neglect the external benefit enjoy by third parties.

This is represented below. 

If only the private benefit is considered, the equilibrium is $E_1$ and the market output will be $Q_1$.

If we were to register all social benefits (private benefit plus external benefit), the equilibrium will be $E_2$ and a higher quantity of $Q_2$ will be produced. This $Q_2$ represents the socially optimum quantity.

However, since only private benefits are taken into account, the society will end up producing at $Q_1$ which is lesser than the socially optimum quantity of $Q_2$. 

Hence, we see that the market fails because society is underproducing goods associated with positive externalities.

In short, we see that externalities are a source of market failure because society will end up producing more or less of what is required.

You might be asking, How do we solve the problem of externalities?

There is no exact remedy for externalities. However, government and private sectors have come up with some ways of reducing the problem of externalities. We discussed this solution here

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