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Unit-23: Market Failure: Meaning and Sources

23.5 Externalities and Market Failure Notes

The one of the main sources of market failure is externalities. This happens due to the lack of property
rights. By ‘Externality’ we mean the situation when the costs or benefits related to a transaction not
only affects the transactors but also other parties. This is also called Third Party Effect.
According to McConnel, “Externalities occurs when some of the benefits or costs associated with
the production or consumption of goods ‘spillover’ on Third Parties i.e. or parties other than the
immediate buyer or seller.”
Example – If any person creates garden in outside of his home and grows various types of beautiful
flowers. Now this work will not only give aroma to his neighbour but also the third person who crosses
at his house. To grow the garden process is called positive externalities. Nobody will pay for it.
In contrast, if anybody fixes a generator in his house, and starts that after cutting the electricity, however
that person gets light but that generator will produce noise pollution and air pollution which negative
externalities will affect to his neighbor as well as the third party. The generator owner does not give any
price for this negative externality. The negative effect bear by neighbour is called negative externality.
If this factor is not included in decision-making, then it creates externality and this is the reason of
market failure. For example, the pollution from factories affects the health of nearby residents. But this
cost cannot add in production cost. This is negative or bad externality.

To describe the externality, it is essential to differentiate the personal cost or profit and social cost or
profit.
In any society, the distributions of factors are optimum when social marginal cost is equal to its social
marginal benefit.
An independent market distributes factors optimally when the personal cost is equal to social cost
and personal profit is equal to social profit. When social cost is more than personal cost then there
will negative externality and when social profit is greater than personal profit then there is positive
externality.

The Benefits and Cost of Personal and Social
1. Private Cost and Benefits: In the process of production, a producer puts factors on process to get some financial
award like wages, interest and taxes etc. This is private cost for a producer. Thus the private cost is the cost which
a producer bears while producing a product. When ready product has bought and consumed by consumer and
the profit gets from it is called private profit. This private profit and private cost has distinguished into public/social
costs and public/social profits.
2. Social Cost: Whenever any financial process occurs, society has also bear some cost along with an individual or firm
(which produces). This social cost is the social cost of financial process for society. In easy words, the social cost is the
cost which all societies bear to produce a product. For example, the cost of vehicle runs on road is the pollution,
defects of road and crowd, which is from vehicles.
3. Social Benefits: The social benefits are the benefits which society gets from an individual’s financial process. So the
society is benefited from an individual’s financial work, is called Social Benefits.

Market Failure calls the government interfere.

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