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An externality in economics is a cost or benefit that has an impact on a party not directly connected to the transaction or activity that produced it. The effects of externalities on the economy and society can be good or harmful.
When someone who is not involved in the activity or transaction must pay the cost of the activity or transaction, this is referred to as a negative externality. For instance, pollution from a factory may have unfavorable externalities by impairing the health of people living nearby, incurring a cost that the manufacturer is not responsible for. Negative externalities also include things like traffic jams, noise pollution, and the depletion of natural resources.
When an activity or transaction has benefits that go beyond the interests of individuals who are directly involved, this is referred to as a positive externality. In order to benefit the larger community, installing solar panels on a building, for instance, can have positive externalities by lowering the total demand for energy. Education, research and development, and the preservation of historical landmarks are more instances of positive externalities.
The genuine costs or benefits of an activity or transaction may not be reflected in the prices that are paid or received as a result of externalities, which can lead to market failures. As a result, there can be an ineffective distribution of resources and an overproduction or underproduction of particular goods or services. Policymakers can use regulations, taxes, subsidies, or other tools to internalize the costs and benefits of an activity or transaction and make sure they are represented in the prices that are paid or received in order to address externalities.
