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Explain why negative externalities are an example of market failure?

Market failure refers to the failure of the market to allocate resources efficiently. Market failure results in allocative inefficiency, where too much or too little of goods or services are produced and consumed from the point of view of what is socially most desirable. Hence when there are negative externalities caused during consumption and production, this causes a welfare loss further more causing market failure.

Negative externalities of production refer to external costs created by producers. For example, consider the problem of environmental pollution, which is created as a side effect of production activities. In the case of a cement factory that lets out smoke into the air and dumps its waste in the ocean. There is a production externality here because besides the firms private costs of production, there are additional cost that spillover onto society due to the air and water pollution.

The pollution has negative consequences for the inhabitants of the area surrounding the factory. we can see this from the diagram below. When there is a negative production externality, the market overallocates resources to the production of the good and too much is produced with respect to the social optimum. This is shown by Qm>Qopt and MSC>MSB at the point of production.

Whenever there is an externality, there is a welfare loss due to the wrong allocation of resources. In the diagram below, the area that is shaded represents the welfare loss. MSC>MSB for all units of output geater than the optimum quantity supplied. This means society would have been better if less were produced.

Negative externalities of consumption refer to the external cost created by consumers. For example, when consumers smoke in public places there are external costs that spill over onto society such as passive smoking and and illnesses due to inhaling the polluted air. From the diagram below we can see that, when there is a negative consumption externality, the market overallocates resources to the production of the goods and more than what is needed is produced with respect to what is socially optimum. This is shown
by Qm>Qopt.

The welfare loss due to negative consumption externalities is shown in diagram by the shaded area.

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