[short note: as I’ve mentioned before I have started a new masters course in Public Policy and Management. I will be publishing my essays on this blog, and this is one of these essays.]
In an economy that has achieved Pareto optimality (social efficiency), any additional changes in the economy would benefit some people only by making others worse off. In the real world however, markets fail to achieve this social efficiency and one of the main reasons for this, is the existence of externalities.
An externality occurs when the welfare of individuals and corporate profits are affected not only by the actions of individuals themselves or their companies but also from acts of third parties. Whenever these individuals or their companies are affected beneficially, there are said to be positive externalities, whereas whenever these individuals or their companies are affected adversely, there are said to be negative externalities. A common example of a negative externality is environmental pollution. Pollution will be used for now on, instead of the more general term of “negative externality”. Continue reading