An externality is an economic term referring to a cost or benefit incurred or received by a third party who has no control over how that cost or benefit was created. In other words, it is an indirect effect of an economic activity that affects people not directly involved in the transaction. Externalities can be positive or negative, and they can occur from production or consumption. Examples of externalities include pollution caused by commuting to work or a chemical spill caused by improperly stored waste.
Externalities are among the main reasons governments intervene in the economic sphere. This is because most externalities fall into the category of so-called technical externalities, where the indirect effects have an impact on the consumption and production opportunities of others, but the price of the product does not take those externalities into account. As a result, there are differences between private returns or costs and the returns or costs to society as a whole. Negative externalities, such as pollution, can lead to market inefficiencies and market failures.
Economists recognize that externalities pose fundamental economic policy problems when individuals, households, and firms do not internalize the indirect costs of or the benefits from their economic transactions. Therefore, some economists recommend government intervention to correct for the effects of externalities. For example, governments and companies can rectify externalities by financial and social measures.
