Externalities disrupt competitive market equilibrium by creating a disparity between private and social costs or benefits.

In a competitive market, equilibrium occurs when the quantity demanded by consumers equals the quantity supplied by producers at a specific price level. This equilibrium reflects the private costs and benefits associated with production and consumption. However, the presence of externalities introduces a divergence between private and social costs or benefits, resulting in a disruption of market equilibrium.

An externality is defined as a cost or benefit that affects an individual or group who did not choose to incur that cost or benefit. Externalities can be classified as either positive or negative. Negative externalities arise when the social cost of production or consumption exceeds the private cost. For example, a factory that emits pollutants into the environment generates a negative externality. In this scenario, the social cost, which includes the costs associated with environmental degradation, is greater than the private cost incurred by the factory. Consequently, this discrepancy leads to overproduction and overconsumption, as the market price fails to reflect the true cost of production, resulting in market failure.

Conversely, positive externalities occur when the social benefit of production or consumption surpasses the private benefit. Education serves as a prime example of a positive externality. The societal advantages of an educated populace—such as reduced crime rates and increased productivity—exceed the private benefits enjoyed by individuals. In such cases, the market tends to underproduce and underconsume, as the market price does not accurately capture the full benefits of consumption, leading to another form of market failure.

In both scenarios, the existence of externalities leads to an inefficient allocation of resources, preventing the market from achieving an optimal outcome. When externalities are present, the market equilibrium is not socially optimal because the market price does not reflect the true social cost or benefit. This results in overproduction in the case of negative externalities and underproduction in the case of positive externalities.

Consequently, externalities have a profound impact on competitive market equilibrium. They create a divergence between private and social costs or benefits, leading to market failures and inefficient resource allocation.