Answer to Question #213435 in Microeconomics for Tanya

Question

How do inefficiencies occur in the market due to externalities.?Explain with Diagram

Answer 1

An externality is a cost or benefit incurred by an unconnected third party as a result of the production or consumption of an item or service

Market failure is the inefficient allocation of products and services available in the market.

Since a product's or service's price equilibrium does not correctly represent the true costs and benefits of the product or service, externalities create market inefficiency

Those externalities which cause market inefficiency are referred to as negative externalities.

Examples of negative production externalities

1. Pollution is produced when coal is used for energy
2. Carcinogens are released into the environment when traditional vegetables are grown using pesticides.

Diagram of negative externality in consumption;

The Marginal Social Cost is higher than the Marginal Private Cost due to external costs.

Producers overlook the external costs to others in free market .As a result, production will be at Q1(where supply=Demand).

This is inefficient socially because in Q1-MSC> MSB

At Q2,social efficiency is achieved when the marginal socialcost equals the marginal social benefit.

The region of dead weight welfare loss is represented by the shaded triangle. It denotes the overconsumption zone (where MSC is greater than MPC)