Why are externalities referred to as market failures Does th

Why are externalities referred to as \"market failures?\" Does the market system actually encourage this behavior? Identify two possible solutions to externalities.

Solution

Externalities are referred to as \'market failures\' because in case of an externality free market fails to provide the societal optimum of the good and hence is unable to maximise society\'s welfare.For example suppose a firm produces a good which results in pollution .This pollution is the externality associated with the good produced.The firm when maximising its profits does take account of this external cost it imposes over the society.Hence the quantity of good it produces is more than the societal optimum.

Market system actually encourages this behaviour because in free market mechanism people are only inclined towards maximising their own profits , they tend to ignore the extra costs they impose over the society through their production activity.

The problem of externality can be solved by various methods.

1) government can impose taxes over the the firm such that its induced to produce societal optimum.

2) Also firms themselves if transaction costs are low could bargain amongst themselves i.e. the polluting firm could be induced to produce societal optimum by compensating him by an amount greater than that he looses due to lower production.

3) Even the 2 firms i.e one who is producing externality and the one facing difficulties due to externality could be merged together.Thus the negative externality would be internalised in this case.