Question

Suppose you have a friend who argues that a free market always yields the best outcomes for society. Provide an​ example, using an​ externality, to counter that view

Answer 1

Ans) As opposed to invisible hand theory, which suggests that market outcome is always the best, the presence of externality shows that market outcome may not be always best for the society.

Externality is the cost or benefit of any activity that falls upon the bystander. It is of two types ÷ positive and negative.

Positive externality is when the bystander bears the benefit of any activity. For eg- education, vaccine, planting trees etc. In this case, since marginal private benefit is less than marginal social benefit, goods will be underproduced without government intervention. That is, market will produce less quantity than socially desirable.

external benefit social benefit private benefit Qmarket Qefficient

Negative externality is when the bystander bears the cost of any activity. Eg- pollution. Here, since social cost is more than private cost, goods are overproduced. That is, in absence of government intervention, market produces the quantity which is more than socially desirable.

external cost Qefficient Qmarket