Externalities??
Answer:
Suppose that I am trying to decide whether to go to college or not. It will cost $100,000 for four years. Suppose, further, that I want to study music, but my salary as a muscian will never pay for my college expenses. This will be a loss to society, if they value having symphonies and orchestras.
The government could give out scholarships, or they could subsidize concerts. Both of these options yield the same thing -- more money to the music field and more musicians.
because there is a cost in producing the desired amount, thus companies do not produce more than required for them to be viable.
government could help in these cases to increase the externalities, for example, by subsidising buyers, or sellers, or by creating property rights so producers can be induced to produce more.
In economics, an externality is a cost or benefit from an economic transaction that parties "external" to the transaction receive. Externalities can be either positive, when an external benefit is generated, or negative, when an external cost is imposed upon others. It is a form of side effect though not necessarily an unintended consequence.
Every decision made by a decision maker (economic agent) will not only have an impact on the decision maker himself but will also have an impact on the other members of the society which is known as externalities.
An externality occurs when a decision causes costs or benefits to third parties (stakeholders), often, though not necessarily, from the use of a public good (for example, production which causes pollution may impose costs on others, making use of the public good air). In other words, the participants do not bear all of the costs or reap all of the gains from the transaction. As a result, in a competitive market too much or too little of the good may be produced and consumed from the point of view of society, depending on incentives at the margin and strategic behavior. If third parties benefit substantially, such as in areas of education or safety, then the good will be under-provided (or under-consumed); if costs to "the public" exceed costs to the individual(s) making the choice in areas such as pollution then the good will be over-provided, from society's point of view. The "point of view" is specified as the greatest collective economic utility for society.
This should be contrasted with purely private economic agreements that do not affect third parties, where the assumption may be made that, if each party is acting in his or her own interests (as defined by utility) and there are no other major market failures, the agreement or exchange improves overall utility for society. Put more simply, if an economic transfer between two parties enhances the utility of both without negatively affecting the utility of any third party, the well being (collective utility) of society is improved; if the utility of others is harmed, it is no longer unambiguously clear that society's collective utility has increased, and may have decreased.
For most economists, the problem of an externality usually concerns the results of market activity. Economists see voluntary exchange as mutually beneficial to both parties in an exchange. On the other hand, either the consumption of a product such as perfume or other luxuries or its production may have external effects — as in the diagram. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost. The left-hand-side of the diagram shows consumption externalities, such as those of perfume, while the right-hand-side shows production externalities, such as those produced by a perfume factory.
Positive Externities and Social optimaL:
From the perspective of a social planner or welfare economist, this will result in an outcome that is not socially optimal. From the perspective of anybody affected by the externality, it is either a negative factor in their lives, as with pollution by the factory (or the wearer), or a boon, such as the pleasant smell of those wearing the perfume (in the opinion of some). In the first case, the person who is affected by the negative externality in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as trespassing on their lungs, violating their property rights. Thus, an external cost may often pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights, as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries and/or legal traditions).
There are a number of potential means of improving overall social utility when externalities are involved. The most efficient means of correcting for externalities is to "internalize" the costs and benefits, for example, by requiring a polluter to repair any damage caused. In many cases, however, internalizing costs or benefits is not feasible or the costs uncertain.
The value of the effects of the externality are difficult to calculate in a technocratic way by economists or social planners, since they reflect the ethical views and preferences of the entire population: it may not be clear whose preferences are most important; interests may conflict; the "value" of the externalities may be difficult to determine; and all parties involved may attempt to influence the policy responses to their own benefit (particularly if "others" can be made to pay for the proposed solutions). Because it may not be feasible to monetize the costs and benefits, some method is (arguably) needed to either impose solutions or aggregate the choices of society. This may be through some form of representative democracy or other means. Political economy is, in broad terms, the study of the means and results of aggregating those choices and benefits that are not limited to purely private transactions.
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