externalities

Externalities are effects of a transaction that impact individuals who are not directly involved in the transaction. They can be positive or negative and may arise from production, consumption, or both. In a negative externality, a producer’s actions create costs for others, such as pollution from a factory affecting nearby residents. In a positive externality, the actions of one party confer benefits on others, such as vaccination reducing disease spread or the spillovers from research and development.

Because externalities cause market prices to diverge from social costs or benefits, markets may fail to allocate resources efficiently. The social cost of a production activity equals the private cost plus the external cost borne by third parties; the social benefit equals the private benefit plus any external benefits. When negative externalities dominate, overproduction may occur; when positive externalities dominate, underproduction may occur.

Policy responses aim to align private incentives with social welfare. Tools include Pigovian taxes or subsidies to reflect external costs or benefits, quantity restrictions or cap-and-trade systems, and regulation. The Coase theorem suggests that if transaction costs are low and property rights are well defined, private bargaining can internalize externalities without government intervention, though in practice transaction costs and distributional concerns often necessitate policy action. Measurement challenges, judicial and administrative costs, and equity considerations complicate responses.

Examples abound, from environmental pollution and traffic congestion to education and public health spillovers. Externalities are a central concept in welfare economics and influence debates on regulation, taxation, and public policy.