When Markets Miss the Mark: Understanding Externalities

As we all believe that in a perfect world, markets are supposed to be perfect ,where all buyers and sellers come together, price adjusts and everyone ends up happy. But in reality not every time markets can work as magic. Sometimes markets miss the mark. Economists called this a Market Failure and one of the biggest culprits behind this issue is something called an Externality.

What is exactly an externality? Well in simple terms, an externality is a side effe

ct of an action that affects other people who are not part of that action. For example, imagine your neighbor decides to throw a late-night party. They’re having fun,  but you’re losing sleep. That’s an externality in action.

There are two types of externality - positive and negative. A positive externality is the hero of the transaction, it is a hidden benefit from the transaction, in other words a good side effect. For example, you get vaccinated , by doing this you not only protect yourself but also others. A negative externality is the villain of the story, it is a hidden cost paid by the society who are not even involved in the transaction. For example, a factory pollutes the air you breathe, leading to serious health issues. 

How can one reduce the problem of externalities? For this, economists and policy makers have given some solutions, they are - Taxes ,  carbon credit on the pollution producers , subsidies by the government on activities with positive spillover , proper rules and regulations for avoiding issues. 

In conclusion, markets are not always perfect and one of the causes of market failure is externalities. They play a huge role in the life of markets. So understanding these externalities helps us to create better policies and make correct decisions.