What are externalities in economics?

Externalities are defined as costs or benefits that impact third parties who are not directly involved in a transaction. This concept is central to understanding market outcomes and the implications of economic activity beyond the buyers and sellers engaged in a transaction.

When an externality occurs, it can lead to market failures because the prices in the market do not reflect the true societal costs or benefits. For example, when a factory emits pollution while producing goods, the health implications for nearby residents are not accounted for in the price of the products. This effect causes a misallocation of resources since the factory does not bear the full cost of its production activities.

Similarly, positive externalities, such as the benefits of a well-maintained public park, positively impact the community members who may not be directly paying for or involved in the park's maintenance. In both cases, the interaction highlights the importance of recognizing how individual actions can have broader implications for society, making it essential for economists and policymakers to address these external effects to improve overall welfare.