What is Externality?

An externality is a cost or benefit caused by a producer that is not financially incurred or received by that producer. An externality can be both positive or negative and can stem from either the production or consumption of a good or service. The costs and benefits can be both private—to an individual or an organization—or social, meaning it can affect society as a whole.

An externality is an event the occurs as a byproduct of another event occurring. An externality can be good or bad, often noted as a positive externality or negative externality.

An externality can also be generated when something is made (i.e. a production externality) or used (i.e. a consumption externality). Pollution caused by commuting to work or a chemical spill caused by improperly stored waste are examples of externalities. Governments and companies can rectify externalities by financial and social measures.

Externalities occur in an economy when the production or consumption of a specific good or service impacts a third party that is not directly related to the production or consumption of that good or service.

Almost all externalities are considered to be technical externalities. Technical externalities have an impact on the consumption and production opportunities of unrelated third parties, but the price of consumption does not include the externalities. This exclusion creates a gap between the gain or loss of private individuals and the aggregate gain or loss of society as a whole.

The action of an individual or organization often results in positive private gains but detracts from the overall economy. Many economists consider technical externalities to be market deficiencies, and this is the reason people advocate for government intervention to curb negative externalities through taxation and regulation.

Externalities were once the responsibility of local governments and those affected by them. So, for instance, municipalities were responsible for paying for the effects of pollution from a factory in the area while the residents were responsible for their healthcare costs as a result of the pollution. After the late 1990s, governments enacted legislation imposing the cost of externalities on the producer.

Many corporations pass the cost of externalities on to the consumer by making their goods and services more expensive.

Externalities can be broken into two different categories. First, externalities can be measured as good or bad as the side effects may enhance or be detrimental to an external party. These are referred to as positive or negative externalities. Second, externalities can be defined by how they are created. Most often, these are defined as a production or consumption externality.

Most externalities are negative. Pollution is a well-known negative externality. A corporation may decide to cut costs and increase profits by implementing new operations that are more harmful to the environment. The corporation realizes costs in the form of expanding operations but also generates returns that are higher than the costs.

However, the externality also increases the aggregate cost to the economy and society making it a negative externality. Externalities are negative when the social costs outweigh the private costs.

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