An externality is a cost or benefit accruing to a person or group of people who are external to a market transaction. When this occurs, the market fails to provide an allocatively efficient quantity of the good or service. Too little is produced in the case of spillover benefits; too much in the case of spillover costs. In some instances, government intervention may be required to correct the market failure.

The graph shows a typical competitive market in equilibrium. Private benefits and costs are reflected in the demand and supply curves labeled D and S, respectively. The price is $50 and 40 units are sold each period. Click anywhere inside the boxes labeled Spillover Benefit or Spillover Cost and enter a value. External benefits are assumed to accrue to consumers while external costs are assumed to accrue to producers. If there are external benefits, the curve labeled D_t illustrates the total benefit to society of each successive unit of the good - the private benefit plus the spillover benefit. Likewise, the curve labeled S_t reflects the total marginal cost of the good - the private and the spillover cost - in the event of a spillover cost. To simulate a government policy, drag either the demand curve or the supply curve in the appropriate direction to correct for the market failure, then click on the New Equilibrium button to observe the market adjust to the policy. Click Reset to restore the initial values.

1. Suppose production of this good imposes external costs of $10 for each unit produced. Does this cause an over or an underallocation of resources to production of this good? How might the government respond to correct this market failure?
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2. Suppose production of this good provides an external benefit of $10 for each unit produced. What is the efficient quantity in this market? How might the government respond to correct this market failure?
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