4.1 Market Failures and Externalities

Market failures arise when the allocation of goods and services by a free market results in inefficient outcomes, where societal welfare is not maximised. One of the key factors contributing to market failures is externalities, which are the costs or benefits that affect third parties who are not directly involved in a transaction.

Externalities are unintended consequences of economic activities that affect individuals or groups who did not choose to incur those costs or benefits. They can be classified into two main types:

• Negative Externalities: These occur when the actions of individuals or firms impose costs on others. For example, a factory that emits pollution into the air can harm the health of nearby residents. This pollution may lead to increased healthcare expenses and lower property values, as affected individuals bear the costs without compensation from the polluting firm.
• Positive Externalities: These occur when the actions of individuals or firms provide benefits to others. For instance, if a homeowner invests in a well-maintained garden, the neighbourhood may experience enhanced aesthetic appeal. This can lead to increased property values for surrounding homes, benefiting other homeowners without direct payment to the gardener.