Externalities exist when individuals (firms) impose costs on or provide benefits to others but do not consider those costs and benefits when deciding how much to consume or produce. Thus externality is a cost or benefit received by a person not involved in a market transaction, and therefore not reflected in the market price of the product being exchanged in the market.There are two types of externalities: positive externalities and negative externalities. A positive externality exists when an individual or a firm making an economic decision does not receive the full benefit of the decision. In this case, the social benefit is greater than the benefit that goes to an individual or a firm. A negative externality occurs when an individual or a firm making a decision does not have to pay the full cost of the decision. If a product has a negative externality, then the cost to society is greater than the cost that the consumer is paying for it. Both positive and negative externalities result in market inefficiencies unless proper action is taken to minimize the adverse impacts of the externalities.

• Describe your understanding of externalities by providing an example of a positive externality and a negative externality. Why do positive and negative externalities lead to inefficiency in the market economy?
• How can externalities be addressed using the private sector and the market system to reduce market distortions of externalities?
• What government policies can help us deal with positive and negative externalities by reducing inefficiency?