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David Pearce How can the presence of externalities cause market failure? In general, an externality is something that is a by-product of a production process but affects a third party externally (the word from which 'externality' is derived). There can be both positive and negative externalities, which can be split up into consumption externalities and production externalities. The table below shows some different externalities: Consumption externalities Production externalities Positive Negative Positive Negative The benefits to the rest of society of people being vaccinated before travelling abroad Noise pollution from people playing loud music in public places The benefits to the environment that arise from the planting of woodland by a forestry company Waste products being dumped into a river by a company But why do these externalities occur and what effect can they have on the market? The graph below shows the exist of net external costs, perfect market will over produce with too many resources allocated to this use, the welfare loss is shown...

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