How do externalities impact competitive market equilibrium?

Externalities disrupt competitive market equilibrium by causing a divergence between private and social costs or benefits.

In a competitive market, equilibrium is achieved when the quantity demanded by consumers equals the quantity supplied by producers, at a certain price level. This equilibrium reflects the private costs and benefits of production and consumption. However, when externalities are present, they cause a divergence between private and social costs or benefits, leading to a disruption in the market equilibrium.

An externality is a cost or benefit that affects a party who did not choose to incur that cost or benefit. They can be either positive or negative. Negative externalities occur when the social cost of production or consumption exceeds the private cost. For example, a factory that pollutes the environment creates a negative externality. The social cost, which includes the cost of environmental damage, is higher than the private cost borne by the factory. This leads to overproduction and overconsumption, as the market price does not reflect the true cost of production, resulting in a market failure.

On the other hand, positive externalities occur when the social benefit of production or consumption exceeds the private benefit. For instance, education is often cited as an example of a positive externality. The social benefits of an educated population, such as lower crime rates and higher productivity, exceed the private benefits to the individual. In this case, the market underproduces and underconsumes, as the market price does not reflect the true benefit of consumption, leading to another form of market failure.

In both cases, the presence of externalities leads to a misallocation of resources, as the market fails to achieve an efficient outcome. The market equilibrium, in the presence of externalities, is not socially optimal. This is because the market price does not reflect the true social cost or benefit, leading to overproduction in the case of negative externalities and underproduction in the case of positive externalities.

Therefore, externalities have a significant impact on competitive market equilibrium. They cause a divergence between private and social costs or benefits, leading to market failures and a misallocation of resources.