Externality

Published Dec 26, 2022

Definition of Externality

An externality is an economic side effect of an activity or transaction that affects someone other than the parties involved in the transaction. That means it is an unintended and uncompensated consequence of an economic activity that affects a third party.

Example

To illustrate this, let’s look at the example of a factory that produces steel. The factory is owned by a company and employs many workers. The company pays its workers a salary, and the workers, in turn, use their income to buy goods and services in the local town. This is an example of a positive externality because the factory’s activities positively affect the local economy.

On the other hand, the factory also produces a lot of air pollution. This air pollution affects the health of people living in the vicinity of the factory. This is an example of a negative externality because the factory’s activities have a negative effect on the local population.

Why Externality Matters

The concept of externalities is important in economics because it helps us to understand the unintended consequences of economic activities. It is important to note that externalities can be both positive and negative. In both cases, however, they lead to market failure (i.e., inefficient distribution of resources). Therefore, it is essential to consider these unintended consequences when making economic or policy decisions to ensure that externalities can be internalized and the benefits of an activity outweigh the costs.