What are externalities?

Externalities are defined as costs or benefits that affect individuals who are not directly involved in a particular economic transaction between buyers and sellers. This means that when an economic activity occurs, the consequences of that activity can spill over to third parties, either positively or negatively.

For instance, if a factory pollutes the air while producing goods, the negative impact of that pollution—such as health issues or reduced quality of life for nearby residents—represents a negative externality. Conversely, a positive externality might occur when someone maintains a beautiful garden that enhances the neighborhood’s aesthetics, benefiting others who didn't contribute to the upkeep of that garden.

Recognizing externalities is crucial for understanding market efficiencies and failures. When externalities are present, the market outcome might not lead to the most efficient allocation of resources, as those effects on third parties are not reflected in the prices of goods or services traded in the market. Addressing externalities often requires government intervention or collective action to internalize these costs or benefits in order to achieve a more socially optimal outcome.