externalities in economics

Running Head : Externalties in economics

Externalities in Economics (Name (Institution (Name of Instructor (Subject

Externalities in Economics

Overview

Externality is yet another significant source of market failure . It is owing to the lack of property rights that externality arises . According to Jaen (2005 , by externality we mean the situation when the cost or benefits related to a transaction not only affects the transactors but also the other parties which is called party effect . Non-inclusion of such effect in decision making causes externality and hence market failure . Jaen added that an

example of this is pollution from factories which adversely affects the health of the people in the neighborhood But such a cost is not included in the estimation of cost of production accordingly there is increase supply . This is called negative or harmful externality . Jaen (2005 ) added that externality could be beneficial as well and he cited an example , the painting of house by individual A may lead in its market value and also that of the other properties in the neighborhood . Thus the benefit accrues to the third party this is an example of positive externality

Before explaining externality further , we must make a distinction between private cost or benefit and social cost or benefit . In a given society , the resources are said to be optimally allocated when the social marginal cost is equal to the social marginal benefit . Free markets would optimally allocate the resources when private costs are equal to social costs and private benefits are the same as social benefits (Jaen , 2005 . There would be negative externality when social cost exceeds private costs and positive or beneficial externality when social benefits exceed private benefits

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Jaen , T . R Ohri , V . K (2005 . Principles of Microeconomics . Page 324 - 332

Externalities arise when one economic agent does not compensate others for his actions which may directly affect their consumption or production possibilities . Smokers , who do not , for example , pay for increasing others ' risk of cancer , or for the discomfort they may cause produce externalities . According to Miyao Kanemoto (1987 , urban life is filled with examples of externalities : manufacturing producers may cause air and water pollution which negatively affects residence and other producer some individuals may have racial prejudice against certain ethnic groups a household may benefit from beautiful gardens of its neighbors firms often prefer to locate in larger cities because of proximity to other firms and an additional traveler in a congested road imposes external cost on other travelers by slowing them down . According to the Fundamental Theorem of Welfare Economics , a competitive equilibrium is efficient in the Pareto optimal sense if all goods are private goods and no externalities exist . This result , however , breaks down if there are externalities . An individual decision maker who generates externalities does not take into account actual external cost or benefits imposed on others his decision must therefore be corrected to account for external effects . Externalities , thus present a case of potential market failure where go government intervention may be...