Externality

Market systems work most efficiently when prices at which goods and services are exchanged accurately incorporate information about social preferences, in which case, the price in question is called the efficiency price or scarcity price. When a price deviates from the efficiency price, it is an arbitrary price, and the transaction in question either imposes costs or confers benefits that are not reflected in the actual market price. These costs and benefits are called externalities. Put in another word, when the action by a party impacts another party that is not meant be affected but rather faces consequences of the first party’s action, then this would be an externality. Externalities can be positive and negative. Pollution is a prime example of a negative externality. When a factory discharges pollutants into the water or air, it imposes costs on those affected by the pollutants. If those costs are not counted in the factory’s costs of production, as is likely in the absence of government regulation, then the factory sells at arbitrary rather than efficient prices, and market efficiency is undermined. Other examples of negative externalities can be traffic congestion, noise, passive smoking, etc. Positive externalities occur when people benefit from the actions of others without paying for that benefit. For example, if one maintain the exterior of his/her house in impeccable condition, one’s actions confer an aesthetic benefit on one’s neighbors and other passersby as well as a monetary benefit to any of one’s neighbors who choose to sell his or her house. Other examples of positive externalities are public lightening, R&D, etc. The concept of positive externality is closely related to public good and free riding. Readers are encouraged to click on those links to extend reading. Externalities are imperfections in a market system and thus constitute a type of market failure. When such failures occur, it is often possible for governments to correct them, for example by taxing polluters and other producers of negative externalities and by subsidizing those who provide public goods. These actions, if calibrated accurately, can bring prices into line with total social costs and benefits, thereby enhancing the efficiency of markets. Adapted from Bevir, M. (2007)