8.4 Positive and Negative Externalities in Consumption and Production

What is an externality

A cost or benefit affecting a third part not involved in a transaction

Why do negative externalities lead to overproduction

Because producers don’t bear the full cost, so output exceeds the socially optimal level

Who do positive externalities lead to underproduction

Because producers or consumers don’t gain the full benefit, so output falls below the socially optimal level

How do externalities cause market failure

Market prices don’t reflect social costs of benefits, causing misallocation of resources

How does absence of property rights lead to externalities

Without ownership, there is no incentive to prevent pollution or overuse, allowing negative effects on others