Externalities and Market Failure

Reasons for market failure

Market Failure occurs when there is an inefficient allocation of resources in a free market. This may occur due to:

Types of market failure:

  1. Positive externalities – Goods / services which give benefit to a third party, e.g. a bee keeper’s bees can pollinate nearby crop fields. Even though this is a good thing, the market system fails to account for the benefit arising from it.
  2. Negative externalities – Goods / services which impose cost on a third party, e.g. smoking causes cancer to those who don’t smoke as well (through passive smoking).
  3. Merit goods – People underestimate the benefit of a particular good, e.g. education. Therefore they under-consume it. Without the government encouragement, the people under-consume such goods.
  4. Demerit goods – People underestimate the costs of good, e.g. smoking. Even with so much campaigns against smoking, people still continue to smoke.
  5. Markets fail to provide public Goods – Goods which are non-rival and non-excludable – e.g. police, national defense. The market simply fails to provide them.
  6. Monopoly Power – when a single firm controls the market they can set higher prices and exploit the consumers.
  7. Inequality – unfair distribution of resources in free market
  8. Factor Immobility – E.g. geographical / occupational immobility
  9. Imperfect and asymmetrical information – where there is no enough information to make an informed choice.


A consequence of an economic activity that is experienced by unrelated third party. An externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit.

Types of externalities:-

There are two types of externality.

  • Positive externality
  • Negative externality

Positive externality:-

A positive externality is a benefit that is enjoyed by a third party as a result of an economic transaction. Third parties include any individual, organization, property owner, or resource that is directly affected. While individuals who benefit from positive externality without paying are called to be free rider. Government can play a role in encouraging positive externalities by providing subsidies for gods or services that generates spillover benefits. Such subsidies provide an incentive for firms to increase the production of goods that provide positive externalities. And, because the spillover benefits goes to society, government subsidies are a way for society to share in the cost of generating positive externalities.


  • When you complete high school, you’ll reap the benefits of your education in the form of better job opportunities, higher productivity, and higher income. A technical degree or college education will further enhance those benefits. Although you might think you are the only one who benefits from your education, that isn’t the case. The many benefits of your education spill over to society in general. In other words, you can generate positive externalities. For example, a well-educated society is more likely to make good decisions when electing leaders. Also, regions with a more-educated population tend to have lower crime rates. In addition, more education leads to higher worker productivity and higher living standards for society in general.
  • Social benefits from the maintenance of a post- officenetwork.
  • A new motorway or road improvement scheme generates third party benefits including reduced transport cost for local firms and generates a regional multiplier effect.


Negative externality:-

A negative externality occurs when an individual or firm making a decision does not have to pay the full cost of the decision. If a good has a negative externality, then the cost to society is greater than the cost consumer is paying for it. Since consumers make a decision based on where their marginal cost equals their marginal benefit, and since they don’t take into account the cost of the negative externality, negative externalities result in market individual inefficiencies unless proper action is taken. Negative externality is a cost that is suffered by third party.third parties include any, organization, property owner, or resource that is indirectly affected.

Examples of negative externalities:-

  • A common example of a negative externality is pollution. For example, a steel producing firm might pump pollutants into the air. While the firm has to pay for electricity, materials, etc., the individuals living around the factory will pay for the pollution since it will cause them to have higher medical expenses, poorer quality of life, reduced aestetic appeal of the air, etc. Thus the production of steel by the firm has a negative cost to the people surrounding the factory–a cost that the steel firm doesn’t have to pay.
  • If you play loud music at night your neighbour may not be able to sleep.
  • If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.
  • If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.
  • If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.



Tehmina Khan contributed to this tutorial