How do externalities affect market failure?

Economics Externalities Questions



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How do externalities affect market failure?

Externalities can lead to market failure by causing a divergence between private and social costs or benefits. When external costs or negative externalities, such as pollution or congestion, are not accounted for in the price of a good or service, the market fails to allocate resources efficiently. This leads to overproduction or overconsumption of goods with negative externalities. On the other hand, positive externalities, such as education or research, are not fully captured in the price, resulting in underproduction or underconsumption. In both cases, the market fails to achieve the socially optimal level of production and consumption, leading to market failure.