Market failure can simply be defined as the process by which the free economic market, when left to demand and supply, fails to correct problems that the system generates.

These 'problems' are called 'externalities' and can be defined as when a third party - someone who was not involved in the original action - is harmed or overally benefited by that action.

There are different types of externalities. Negative externaliteis are harmful to third parties, positive externalities are overally beneficial.

If the externality is caused by us - the consumers - it is a consumption externality. If it caused by a producer it is a production externality. The table above lays it all out nicely.

To understand how to draw externalities on the diagram we change our demand and supply a bit and re-interprate it. Demand - how much we are willing to pay - becomes our Marginal Benefit (if we were willing to pay $10 for a t-shirt, the benefit we get from it can be shown as $10), whilst Supply - how much we are willing to produce - becomes Marginal Cost. This is seen in Diagram 1.