Market Supply and Demand

• typically, well-functioning markets allocate the sale of goods to the buyers who value them the most

• typically, well-function markets allocate the production of goods to those who can produce the goods at the least cost

• well-functioning markets produce goods and services efficiently and this leads to efficient outcomes

• efficient outcomes arise because there are gains from trade and in these transactions the sellers and buyers typically incur all of the costs and benefits from the transaction

• sometimes, however, there are some costs (or benefits) that are incurred by people not involved in the transaction

  • external costs: the cost that fall on bystanders not involved in the market transaction

  • external benefits: that benefits that fall on bystanders not involved in the market transaction

  • externalities: the external costs and benefits that fall on bystanders

Externalities

• externalities can arise when the private costs aren’t equal to social costs

• can arise when the private benefits aren’t equal to total social benefits

• when there are negative externalities, the market produces too much of the good

• when there are positive externalities, the market produces too little of the good

• arises when a person engages in an activity that influences the well being of a bystander and the bystander neither pays nor receives compensation

Examples of Negative Externalities

• a negative externality exists when the production (or consumption) of results in costs imposed on society that aren’t explicitly or implicitly paid for by the customer (or producer)

• ex:

  • a business that pollutes the air or water

  • if you take antibiotics too often. a resistant bacterial strain is more likely to form and be less effective for others

  • if someone smokes near you, someone else may be bothered by second-hand smoke