Externalities arise when the actions of one person affect others from "summary" of Public Finance by Harvey S. Rosen
Externalities occur when the actions of one economic agent affect the well-being of another economic agent in a way that is not transmitted through prices. This can lead to market outcomes that are not efficient from society's perspective, as individuals do not take into account the full social costs or benefits of their actions.
Negative externalities arise when one person's actions impose costs on others without compensation. For example, when a factory emits pollution that harms the health of nearby residents, these costs are not reflected in the price of the goods produced by the factory. As a result, the factory may produce too much of the good, leading to an inefficiently high level of pollution.
On the other hand, positive externalities occur when one person's actions confer benefits on others without compensation. For instance, when an individual gets vaccinated against a contagious disease, not only does that person benefit from reduced risk of illness, but others in the community also benefit from lower likelihood of exposure to the disease. However, the individual may not take into account these external benefits when deciding whether to get vaccinated.
In the presence of externalities, the market equilibrium is not efficient because individuals do not consider the full social costs or benefits of their actions. This can lead to overproduction of goods with negative externalities and underproduction of goods with positive externalities. As a result, government intervention may be necessary to correct these market failures and achieve a more efficient allocation of resources.
The government can improve overall welfare and promote a more efficient allocation of resources in the economy.
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