Figure 16-1 Externalities Lead to Allocative Inefficiency
from using the product, however intangible those benefits may be. Social
benefit includes the private benefits plus whatever benefits accrue to third
parties.
Discrepancies between private cost and social cost, or between private benefit and social
benefit, occur when there are externalities. The presence of externalities, even when all
markets are perfectly competitive, leads to allocatively inefficient outcomes.Externalities arise in many different ways, and they may be harmful or
beneficial to the third parties. When they are harmful, they are called
negative externalities; when they are beneficial, they are called positive
externalities. Figure 16-1 shows why an externality leads to allocative
inefficiency, even though the market is assumed to be perfectly
competitive. Here are two examples.