Externalities are costs or benefits related to a good or service that fall on others besides the buyers and sellers of that particular good or service. They are sometimes called spillovers, neighborhood effects, external costs or benefits, or external economies of diseconomies. Thus externalities may be beneficial or detrimental to the well being of those affected. They are not reflected in free market prices. Positive externalities are the uncompensated benefits that are received by individuals who are not directly involved in the production of consumption of goods. The act of producing or consuming goods generates benefits to third parties who do not have to pay for them. Some examples of positive externalities include restored historic buildings and immunizations. Negative externalities are the uncompensated costs that are borne by individuals who are not indirectly involved in the production or consumption of goods. The act of producing or consuming generates costs to third parties who are not compensated to suffer or endure them. Some examples of negative externalities include cigarette smoking and vehicle exhaust. Externalities arise because the free marker mechanism fails to take into account the differences between the private and social costs and benefits in an economic activity. The free marker only responds to purely private price signals. In other words, private costs and private benefits determine what goods and bought and sold in the free market.
Pure public goods have very strong spillover of externalities. They are characterized by non-excludability and non – rivalry. Examples include defense, law and order, street lighting and lighthouses. It is generally not possible to exclude people from these services. Public goods are also non-rival in that one person’s use of the good does not deprive any other person of the use of the good as well. For example, if one person benefits from the peace and security in a country that is provided for the armed forces and the police force, this does not mean that this person can use up this peace and security. It is non rival in that there is exactly the same quantity and quality of peace and security that the other persons can benefit. The non excludability and non rivalry in the use of public goods means that there will be no economic incentive for people to pay for these goods. There will also be hordes of free rides. Hence, it is argued that public goods should, in general, be provided by the government and financed out of general taxation.
Merit goods are good that are deemed to be desirable. Examples include education, culture, museums, public parks and health care services. These goods confer benefits on society as a whole in excess of the benefits enjoyed by individual households. Such goods are considered intrinsically worthwhile to provide in greater volume for the long term benefit of the people as a whole. If these goods are supplied entirely through the market, then they will be underused by people. This implies a sub-optimal allocation of resources. Therefore, it is argued that the government should encourage the consumption of merit goods by providing them free of charge to households or subsidizing them to lower their market price to make them more affordable. It is, however, important to notice that unlike public good, merit good may be produced by the private sector.
Demerit goods are goods that impose negative externalities on society as a whole. Examples of demerit goods are pornography, addictive drugs, tobacco and cigarettes. The harmful affects of cigarette smoke are well known. Notwithstanding the high axes on a packet of cigarettes, the price that a smoker pays for cigarettes does not including the cost of providing health care to the smoker, and to other non smokers affected by the passive smoke. The cost of cigarette smoking is borne by the government providing health care services and the nation, as there will be a loss in national productivity. This implies a suboptimal allocation of resources because the market price is less that the true price of consumption, and thereby encourages over consumption of such goods.
It has been argued that the free market fails to allocate resources efficiently according t o what the people and society needs. A major criticism of the free market mechanism is that it allocated resources based on effective demand, that is, demand back by purchasing power than on demand based on the needs of a society.
The free market system is able to allocate scarce economic resources efficiently if private costs are the same as social costs, and private benefits are the same as social benefits. But in the most cases, they are not the same. It is then argued that the price mechanism fails to take into account social cost and social benefits, and therefore fails in its role to allocate resources to their optimum use. Market failure is the result of a sub optimal allocation of resources in a country.
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