What is Market Equilibrium? 

The economy of a country or any place depends on the market demand and market supply of goods and services.

The Demand Curve: It shows how much people are willing to purchase a particular product

The Supply Curve: It shows the supply of that product which the producers or suppliers are willing to sell within a given period and at the given market price.

Therefore, the market equilibrium takes place when the market demand curve intersects the market supply curve giving us the equilibrium price and equilibrium quantity for which the commodity can be sold and purchased in an economy. When the market equilibrium is achieved, it is generally assumed that all the allocation of resources is done efficiently. It is also assumed that there is just a distribution of income and resources in the economy, which gives the optimum output that is beneficial for the society and the producer as well. In other words, market equilibrium is the phenomenon in which market supply and demand balance each other.  

Market failure happens when the market cannot stay in equilibrium. Market failure happens when the market is not able to allocate the resources in a correct format so that the equilibrium quantity and the equilibrium price of a commodity to be achieved. In this case, the market either over allocates or under allocates the resources for production. Due to the market failure, externalities arise.  

Market Failure

Whenever there is a free market, the market equilibrium is supposed to exist but at times when the market itself cannot correct its failures, then the government being the monopoly head of the country, interferes in the free market operations to correct the market failure. Two of the most important tools which the government uses in a free market are the taxation or rate of taxes which is being imposed to correct the externalities, and also subsidy that helps those who create positive externalities in the economy. 

Externalities: It is the occurrence that takes place due to the production or consumption of some commodity, and the effect of which any of the third parties who are not directly related to the production or consumption process but somehow or the other they are affected due to the activities carried out either by the consumer or by the producer.   

Externalities in society usually take place when the market does not work according to its mechanism, which is generally called market failure. This means that the market fails to allocate the cost and benefit of the society in the proper manner, which results in the imbalance or disequilibrium in the society in terms of the distribution of income distribution of commodities.   

Externalities also happen due to the fact of property rights. When someone or the other is having any kind of property rights over a specific kind of property, then he or she can use it either for the benefits of the society, which is popularly known as the social benefit or external benefits, or for producing private benefits but causing external costs. 

The Types of Externalities

Positive Externalities: It causes benefit to the society due to the activity carried out by the producer or the consumer. Positive externalities happen when there is a social benefit in the society, and the individual who is creating that positive externality is not compensated for the good that he or she is doing for the society, but some way or the other the locality or the area where the individual is reciting is creating benefit to others. 

For example, positive externalities happen to an individual when the individual has completed the studies and decided to provide free education to the children residing in that area, particularly for the unprivileged. Therefore, when the individual initiates the plan of building a school, then the society is getting benefited, but in return, the individual is not compensated for creating the benefit to the society.

The positive externalities happen in an economy when public goods are distributed by the government to society. Now it is the common people who are getting benefited from it, but in turn, the government is not getting compensated for the positive externalities. Now the market is not able to adjust with the excess supply of the goods, and hence the market is over-allocating the resources, which leads to market failure. 

In simple words, when activity happens and that creates a social benefit to the people of that area, and the person who is creating this positive externality is not compensated, then it means that the externalities are created but in a positive sense. 

Negative Externalities: It causes the cost to the third parties or to the individuals who are not directly related to the activity that is being carried out.

Negative externalities happen in society when the production of any goods produces external costs to the third party who is not directly involved in the production process. In other words, It is the spillover cost that has to be built by the third party.

For example, Assume there is a leather factory closely located in an area where there is a river flowing nearby. The production of Labour causes air and water pollution. The health of the people residing there is affected by drinking the water and inhaling the air. Hence the cost of treatment in the hospital is paid by the people for which the factory does not take responsibility with anything and neither there is any kind of external cost that is being imposed on the producer of the leather factory for creating such external cost to the third parties who are not even involved in the production of leather in any way. 

In most cases, it is seen that due to the negative externalities, businessmen or industrialists get the private benefit, and there is no payment of private costs for compensation. Therefore, to restrict the negative externalities to some extent is by imposing Pigouvian tax.

Pigouvian tax It is a kind of tax that is being imposed on the producers, industrialists, or businessmen who create external costs to the society. This external cost is mainly in terms of pollution, damage to health, congestion in the society, and so on.  The Pigouvian tax was discovered and formulated by Pigou, who used various methods to design this tax, where the society gets compensation due to the external cost that is being created by industrialists or businessmen for the purpose of production of goods and services.

Similarly, there should be some incentive or benefit that the individual should get for creating positive externalities in society. The government should provide some kind of subsidies to those who are creating positive externalities either by consumption or by production. It is also important to keep in mind that the negative externalities that are being created in the economy, which is inefficient for the economy to work, taxation should be imposed on such individuals who are responsible for creating them. Thus, important regulation must be taken up by the government to balance out the incentive and the inefficient effects of the respective externalities created. 

As the name suggests for both the externalities, positive and negative, positive externalities cause good to the society, which will create social benefit, and negative externalities cause social trouble.

Context and Applications 

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for 

• B.B.A. in Finance   
• M.B.A 
• B.A. Economics
• M.A. Economics