Externalities can distort market outcomes from "summary" of Economics of the Environment by Robert N. Stavins
The presence of externalities in economic transactions can lead to market outcomes that are different from those that would exist in their absence. Externalities are the costs or benefits that are not reflected in the prices of goods and services. When externalities are present, market prices do not fully reflect the social costs or benefits of production and consumption. Negative externalities occur when the production or consumption of a good or service imposes costs on third parties that are not compensated for. For example, the production of a certain good may result in pollution that harms the health of individuals living nearby. Since the producer does not have to bear the cost of this pollution, they have no incentive to take it into account in their production decisions. This can lead to an overproduction of the good from a social perspective. On the other hand, positive externalities occur when the production or consumption of a good or service benefits third parties that are not compensated for. For example, investing in education not only benefits the individual receiving the education but also benefits society as a whole through increased productivity and innovation. However, since the individual does not capture all of the benefits of their education, they may not invest in education as much as would be socially optimal. In the presence of externalities, market prices do not reflect the full social costs or benefits of production and consumption. This can lead to a misallocation of resources, with too much of some goods being produced and too little of others. As a result, externalities can lead to market outcomes that are inefficient from a social perspective. Policymakers have a role to play in addressing externalities and correcting market failures. One approach is to internalize the external costs or benefits by imposing taxes or subsidies that reflect the externalities. For example, a tax on carbon emissions can internalize the costs of pollution from the production of goods and services. By doing so, policymakers can help to ensure that market outcomes reflect the true social costs and benefits of production and consumption.
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