Externality

In economics, an externality, or transaction spillover, is a cost or benefit that is not transmitted through prices or is incurred by a party who was not involved as either a buyer or seller of the goods or services causing the cost or benefit. The cost of an externality is a negative externality, or external cost, while the benefit of an externality is a positive externality, or external benefit.

In the case of both negative and positive externalities, prices in a competitive market do not reflect the full costs or benefits of producing or consuming a product or service. Producers and consumers may neither bear all of the costs nor reap all of the benefits of the economic activity, and too much or too little of the goods will be produced or consumed in terms of overall costs and benefits to society.

For example, manufacturing that causes air pollution imposes costs on the whole society, while fire-proofing a home improves the fire safety of neighbors. If there exist external costs such as pollution, the good will be overproduced by a competitive market, as the producer does not take into account the external costs when producing the good. If there are external benefits, such as in areas of education or public safety, too little of the good would be produced by private markets as producers and buyers do not take into account the external benefits to others. Here, overall cost and benefit to society is defined as the sum of the economic benefits and costs for all parties involved.

The term "externalities" is regularly misunderstood by some critics of economics, who allege that it is an attempt to relabel the socially disruptive consequences of corporate activity, and frame them as inevitable and acceptable. However, this does not reflect the actual meaning of the term. In fact, economists often use externalities as a justification for government intervention in the economy.