What is an externality in economic transactions?

An externality in economic transactions refers to a cost or benefit that affects individuals or entities who are not directly involved in the economic activity or decision. This concept highlights how certain actions can have consequences that extend beyond the immediate participants in a transaction. For example, pollution from a factory can negatively impact the health and well-being of nearby residents who are not part of the production process. Conversely, a beekeeper maintaining healthy bee populations can provide the beneficial side effect of improved crop pollination to neighboring farms, benefiting those farmers without their having to pay for the service.

This understanding of externalities is crucial as it underscores the importance of recognizing the broader impact of actions in the economy, which can inform policy decisions, such as regulation or taxation aimed at mitigating negative externalities or promoting positive ones.