Externality

An externality is a cost or benefit arising from an economic activity that affects third parties who are not directly involved in the market transaction and is not reflected in prices. Externalities can be negative, imposing costs on others, or positive, conferring private benefits on people who are not participants.

They can arise in either production or consumption. Production externalities occur when the production of a good imposes costs or benefits on others; consumption externalities occur when consuming a good affects others. Examples include negative production externalities such as pollution from a factory that harms nearby residents; positive production externalities such as knowledge spillovers from research that benefiting other firms. Positive consumption externalities include vaccination, which reduces disease spread and benefits society, while negative consumption externalities include smoking in shared spaces.

Because externalities are not priced, markets may produce too much pollution or too little education relative to the social optimum. This misalignment is a form of market failure. Policy responses aim to internalize externalities and bring private incentives in line with social costs and benefits. Tools include Pigouvian taxes or subsidies, regulations, and tradable permits. The Coase theorem argues that if property rights are well defined and transaction costs are low, private bargaining can achieve efficient outcomes regardless of initial allocations of rights.

Limitations include difficulties in measuring external effects, high transaction costs, and information asymmetries, as well as externalities that are diffuse, long-term, or global, such as climate change. Externalities are central to welfare economics and public policy, shaping analyses of social surplus and policy design.