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Paper Topic:

“Explain the concept of externalities in economics. The impact of externalities in resource allocation and how it could be dealt with.”

Running head : Externalities and their effects

Externalities and their effects

[Writer 's name]

[Institution 's name]


According to the Economists a freely competitive market has the efficient allocation of resources . The situation in which the efficiency of the resources allocation is maximized , known as Pareto Optimality . Market failure is the term used for the conditions in which the free unregulated markets fails to achieve the efficient allocation of the resources or the condition of Pareto -optimality is disturbed due to the non-fulfillment of any assumption of the Pareto-optimal

outcome Market failures can result in the following situations


Social priorities such as equity

Imperfect Competition

Other missing markets


Externality can be defined as A situation in which the production or consumption decision directly affects the production or consumption of others other than through market prices (Begg , 1991

There are three types of externalities

Positive Externality

Negative Externality

Pecuniary externalities

1 .Positive Externality

As can be understood from the caption positive externality creates the inadvertent benefit or advantage for other people . For instance if a person got his home painted he enhances the beauty of the street and give the consumption benefit to the neighboring people and the people passing through the street . Another example can be by putting light in front of the door of his home the person may not only serve his purpose but also will provide the benefit to others also

2 . Negative Externality

In the same manner the negative externality impose the inadvertent cost or loss to others . For example the by discharging the polluted water in the river a factory imposes additional cost to the anglers and the people consuming fish by making them eat the fish from the contaminated water which can cause them illness . Without any Governmental intervention the firm will keep on producing till the point at which marginal private cost equals its marginal revenue (optimum level for firm ) without paying any cost of using the environment by disposing the waste . This cost will be levied on society . On the other hand the social optimum will be the point at which the sum of the marginal private cost and marginal pollution damage (marginal social cost ) will be equal to the marginal revenue (Demand

In case of non-provision of the clear property rights in the use of the natural environment for the purpose of wastage disposal the market will not be able to gain the position of pareto optimality . The factory will keep on using the environment without bearing any cost and hence selling its production at cheaper price . Hence by polluting the water the firm is keeping the resources away from making them used by others in efficient manner . Hence the firm can sell its products at lower costs as it is subsidized by the society in shape of the provision of free waste disposal facility . With the provision of waste disposal facility the does not have to incur any cost in the arrangement of the water disposal plan . On...

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