Externalities contribute to inefficiencies in market outcomes by causing either overproduction or underproduction, which distorts the allocation of resources.

An externality is defined as a cost or benefit that affects individuals who did not choose to incur that cost or benefit. Since these externalities are not reflected in market prices, the market fails to allocate resources efficiently. This phenomenon is referred to as market failure.

Negative externalities, such as pollution emitted by a factory, impose costs on third parties. In this scenario, the social cost, which is the sum of the private cost and the external cost, exceeds the private cost. Because the market price does not account for the external cost, producers tend to overproduce, resulting in a quantity that surpasses the socially optimal level. This overproduction generates a deadweight loss, signifying inefficiency within the market.

Conversely, positive externalities, such as the societal benefits derived from education, provide advantages to third parties. In this case, the social benefit, which is the sum of the private benefit and the external benefit, is greater than the private benefit. However, since the market price fails to reflect the external benefit, consumers tend to underconsume, leading to a quantity that falls short of the socially optimal level. This underconsumption also results in a deadweight loss, indicating further market inefficiency.

Additionally, externalities can result in inequitable outcomes. For example, the burdens of negative externalities are often disproportionately borne by those least equipped to handle them, such as low-income communities living near polluting industries. This situation can exacerbate social inequalities and lead to additional inefficiencies.

In summary, externalities can disrupt market outcomes and create inefficiencies by causing either overproduction or underproduction. They exemplify market failure, wherein the market, when left to operate independently, fails to allocate resources in a manner that maximizes social welfare. Understanding externalities is essential for policymakers, as this knowledge can inform the design of interventions aimed at correcting these market failures and enhancing overall efficiency.