Sometimes there are benefit and costs that arise in the market that go uncompensated.
These are called externalities.
A positive externality is a benefit that is enjoyed by society, but society doesn’t pay to receive it.
- “I enjoy shade from my neighbour’s tree, and it doesn’t cost me anything.”
A negative externality is a cost suffered by society, and the instigator isn’t made to pay for the damage.
- “My neighbour’s dog barks at night and keeps me awake, and I don’t get compensation.”
Externalities cause welfare in a market to depend on more than just the value to the buyers and cost to
the sellers, and can lead to inefficient markets.
Negative externalities lead markets to produce more than is socially desirable.
Positive externalities lead markets to produce less than is socially desirable.
We call a loss of surplus a deadweight loss due to the externality.
The government can internalize an externality by imposing a tax in the producer to get them to produce
less – to produce the socially desirable quantity. This tax is known as Pigovian Tax, levied on each unit of
The government can also regulate the amount of pollution a firm may produce. It may sell permits to
firms allowing them a certain amount of pollution. Forms which can reduce pollution at lower costs can
sell these permits to other firms which can only reduce pollution at high costs and may not even bother
- Consider a penicillin treatment for STDs.
- Everyone benefits from the people who take STDs.
The social desirable level of output is
greater than the market equilibrium
level of output. In other words, we
are not producing enough of the