For markets to work efficiently there are two conditions that should be met; first is that the demand curve must represent all the consumers’ full willingness to pay, second, the supply curve must represent the full production cost of all the suppliers which includes not only direct but indirect cost as well. Now if the markets spill over some of their benefits and cost of the services and goods to third parties who have no representation on demand and supply curves then this condition is called an externality. These benefits and costs that markets do not include in their costs and benefits are considered external to transactions of the market.
There are two types of externalities one is positive and the other is a negative externality. The positive externality is due to demand-side failure and negative externality is due to supply-side failure. Now below we will discuss both the cases one by one.
The supply-side failure causes negative externalities. A negative externality occurs when suppliers do not consider the indirect cost of production that third parties are paying. These costs are important to consider because if suppliers account for these costs in their production process then their supply curve would shift to lefts where their price and quantity to be produced would be changed.
For example, the free market system considers only the suppliers and producers of cigarettes to bear all the costs and benefits of the product. However, there is some external cost that third parties pay. Like the damage, the smoke causes to the second-hand smoker’s lungs. Or consider the smoke and pollution that factories make and release in the air make people of those areas breathe polluted air. So from these cases, it’s clear that each unit that suppliers produce the total cost that also includes the cost that third parties are paying would be higher than total benefits.
Through the graph, it will be more clear why the negative externality causes the surplus in the market. As we can see in the graph if the supplier does not consider the cost that the third party is paying per unit then their supply curve is of organ color at which the equilibrium quantity is Qe. But this is not a true representation of the cost of production because as we know in economics no launch is free so that’s why we have to consider the cost that third parties are bearing. If we add those costs in the total cost of production then the supply curve would move toward the left as shown in the graph with red color. This new supply curve represents the social marginal cost that is the cost which both supplier and society is paying. Now as the supply curve shows the full cost of production so the quantity supplied is also decreased to the optimal quantity that consumers actually want to buy at this social marginal cost. The green triangle in the graph represents the inefficiency of the market if the suppliers produce equilibrium quantity. The reason for this is that consumers do not want to purchase such goods for which marginal cost is higher than the marginal benefit which is shown in graphs with cyan color that when we produced equilibrium quantity the marginal benefits are less than social marginal cost.
A positive externality occurs due to demand-side failure. Positive externalities occur when demand curves do not represent all the consumers’ willingness to pay for the external benefits they are enjoying from services or products. This cost is important to consider because it will shift the demand curve to the right due to this the equilibrium price and quantity changes.
For example, if Sarah wants vaccination for COVID-19 to cure her disease but others in her surrounding do not have this disease, they do not want vaccination. But still, they are ready to pay for the vaccination so they do not get infected through this disease. Now the problem is that the demand curve does not represent the third-party willingness to pay which causes inefficiency in the market.
Graphs will help us to understand why the positives externalities create a shortage in the market. As we can see when the willingness of third parties is not included the equilibrium is Qe but this is not a true representation of demand in the market. So when we add the willingness of those third parties to pay our demand curve shifts to the right which is represented by red color in the graph. Now, this demand curve tells the optimal quantity that buyers actually want to buy. So that’s why positive externality causes a shortage in the market and makes the market inefficient.