How does the presence of externalities affect the market outcome in a competitive market?

The presence of externalities in a competitive market can significantly affect the market outcome. Externalities are costs or benefits that affect third parties who are not involved in the production or consumption of a good or service. When externalities are present, the market may fail to allocate resources efficiently.

Negative Externalities: When negative externalities are present, such as pollution from a factory, the cost to society is greater than the private cost to the producer. This leads to overproduction and a higher quantity than is socially optimal.

Positive Externalities: In the case of positive externalities, such as vaccinations, the benefit to society is greater than the private benefit to the consumer. This leads to underconsumption and a lower quantity than is socially optimal.

To address these issues, governments often intervene with policies like taxes, subsidies, or regulations to correct the market outcome and achieve a more socially efficient allocation of resources.

For further reading, please refer to the works of Arthur Pigou and Ronald Coase on externalities and market failure.