What is a negative externality?

A negative externality refers to a cost that impacts individuals or groups who did not choose to incur that cost. This concept is crucial in economics as it highlights the consequences of economic activities that extend beyond the primary participants involved in a transaction. For instance, when a factory emits pollution during production, nearby residents may suffer health issues or diminished property values without having any say in the factory's operations.

Negative externalities often result in market failure, as the true costs of production are not reflected in the market prices. This can lead to overproduction of goods that generate negative externalities, since the producers do not bear the costs associated with the damages caused to third parties. Consequently, addressing negative externalities often requires intervention through taxes, regulations, or other policy measures to ensure that those responsible for the externality account for its impact on others. This helps align private incentives with social costs, leading to more efficient outcomes in the economy.