How Do Externalities Affect Equilibrium and Create Market Failure?

Externalities can be both positive and negative. They exist when the actions of one person or entity affect the existence and well-being of another. In economics, there are four different types of externalities: positive consumption and positive production, and negative consumption and negative production externalities. As implied by their names, positive externalities generally have a positive effect, while negative ones have the opposite impact. But how do these economic factors affect market prices and market failure? Read on to find out more about externalities and their impact on the market.

Key Takeaways

  • An externality stems from the production or consumption of a good or service, resulting in a cost or benefit to an unrelated third party.
  • Equilibrium is the ideal balance between buyers' benefits and producers' costs, while market failure is the inefficient distribution of goods and services in the market.
  • Externalities lead to market failure because a product or service's price equilibrium does not accurately reflect the true costs and benefits of that product or service.

What are Externalities?

An externality is a cost or benefit that stems from the production or consumption of a good or service. They are generally the unintended, indirect consequences incurred in everyday economic operations. Externalities, which can be both positive or negative, can affect an individual or single entity, or it can affect society as a whole. Those impacted by externalities—usually third parties—have no control over and never choose to incur the costs or benefits. It is primarily the responsibility of those generating externalities to account for them and manage them as much as possible.

Negative externalities usually come at the cost of individuals, while positive externalities generally have a benefit. For example, a crematorium releases toxic gases such as mercury and carbon dioxide into the air. This has a negative impact on people who may live in the area, causing them harm. Pollution is another commonly known negative externality. Corporations and industries may try to curb their costs by putting in production measures that may have a detrimental effect on the environment. While this may decrease the cost of production and increase revenues, it also has a cost to the environment as well as society.

Meanwhile, establishing more green spaces in a community brings more benefit to those living there. Another positive externality is the investment in education. When education is easy to access and affordable, society benefits as a whole. People are able to command higher wages, while employers have a labor pool that's knowledgeable and trained.

Governments may choose to remove or reduce negative externalities through taxation and regulation, so heavy pollutants, for example, may be taxed and subject to more scrutiny. Those who create positive externalities, on the other hand, may be rewarded with subsidies.

Governments may tax or regulate negative externalities, while subsidizing positive ones.

Externalities and Market Failure

Externalities lead to market failure because a product or service's price equilibrium does not accurately reflect the true costs and benefits of that product or service. Equilibrium, which represents the ideal balance between buyers' benefits and producers' costs, is supposed to result in the optimal level of production. However, the equilibrium level is flawed when there are significant externalities, creating incentives that drive individual actors to make decisions which end up making the group worse off. This is known as a market failure.

Negative Externalities

When negative externalities are present, it means the producer does not bear all costs, which results in excess production. With positive externalities, the buyer does not get all the benefits of the good, resulting in decreased production. Let's look at a negative externality example of a factory that produces widgets. Remember, it pollutes the environment during the production process. The cost of the pollution is not borne by the factory, but instead shared by society.

If the negative externality is taken into account, then the cost of the widget would be higher. This would result in decreased production and a more efficient equilibrium. In this case, the market failure would be too much production and a price that didn't match the true cost of production, as well as high levels of pollution.

Positive Externalities

Now let's take a a look at the relationship between positive externalities like education and market failure. Obviously, the person being educated benefits and pays for this cost. However, there are positive externalities beyond the person being educated, such as a more intelligent and knowledgeable citizenry, increased tax revenues from better-paying jobs, less crime, and more stability. All of these factors positively correlate with education levels. These benefits to society are not accounted for when the consumer considers the benefits of education.

Therefore, education would be under-consumed relative to its equilibrium level if these benefits are taken into account. Clearly, public policymakers should look to subsidize markets with positive externalities and punish those with negative externalities.


One obstacle for policymakers, though, is the difficulty of quantifying externalities to increase or decrease consumption or production. In the case of pollution, policymakers have tried tools—including mandates, incentives, penalties and taxes—that would result in increased costs of production for companies that pollute. For education, policymakers have looked to increase consumption with subsidies, access to credit, and public education.

In addition to positive and negative externalities, some other reasons for market failure include a lack of public goods, under provision of goods, overly harsh penalties, and monopolies. Markets are the most efficient way to allocate resources with the assumption that all costs and benefits are accounted into price. When this is not the case, significant costs are inflicted upon society, as there will be underproduction or overproduction.

The Bottom Line

Being cognizant of externalities is one important step in combating market failure. While price discovery and resource allocation mechanisms of markets need to be respected, market equilibrium is a balance between costs and benefits to the producer and consumer. It does not take third parties into effect. Thus, it is the policymakers' responsibility to adjust costs and benefits in an optimal way.