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Externalities



Firms that make and sell paper also create as a a by-product of the manufacturing process a chemical called dioxin. Scientists believe that once  dioxin enters the environment it raises the population’s risk of cancer, birth defects and other health problems.
 

To use Adam Smith’s famous metaphor the invisible hand of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society derives from that market. 



Market do many thing well but they do not do everything well. We examine why markets sometimes fail to allocate resources efficiently how government policies can potentially improve the market’s allocation and what kinds of policies are likely to work best.



The market failures examined in fall under a general category called externalizes. An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is adverse it is called a negative eternality if it is called a positive externality. In the presence of externalities society’s interest in a market  outcome extends beyond the well-being of buyers and sellers who participate in the market it also includes the well-being of bystanders who are affected indirectly. Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply the market equilibrium is not efficient when there are externalities. That is the equilibrium fails to maximize  the total benefit to society as a whole.

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