Final answer:
Externalities are the positive or negative outcomes of economic activities on third parties. Positive externalities, like solar panel installation, benefit society while negative externalities, such as pollution from factories, harm it. Both can lead to market failure due to misallocation of resources and deviation from the equilibrium price and quantity.
Step-by-step explanation:
Externalities are consequences of an economic activity experienced by unrelated third parties; they can be either positive or negative. When companies or individuals engage in activities that impact the environment, these effects can manifest at local, state, and national levels, influencing overall welfare.
Examples of Positive and Negative Externalities
Positive externalities occur when the actions of a firm or household result in benefits to others that they do not pay for. For instance, when a business installs solar panels, it not only reduces its own electricity costs but also contributes to the reduction of greenhouse gas emissions, which benefits the environment and society at large.
Negative externalities are when the actions of a firm or household have harmful effects on others. A classic example is a factory that emits pollutants into the air, which may increase healthcare costs for the local population and degrade the natural environment.
To understand how these externalities impact markets, we can also look at equilibrium price and quantity. This is where the quantity demanded by consumers matches the quantity supplied by producers. However, when negative externalities are present, the market tends to overproduce since not all costs are reflected in the market price, leading to market failure. Conversely, positive externalities can lead to underproduction as firms do not receive all the benefits their products create, making them produce less than what would be socially optimal.
Firms contribute to market failure when they do not bear the full costs of their production, as is the case with negative externalities. This misallocation of resources results in overproduction and damage to the environment.