Externalities are the costs or benefits of a market transaction that are borne (that is, paid for in some way) by parties that are not directly engaged in that transaction. Most costs and benefits of economic actions are internalized (that is, paid for by the producer or the consumer) such that those involved in the transactions see the full incentives and disincentives of their actions. That is, , the price you pay for something often reflects the benefit you enjoy in consuming thata good or service and the cost the provider pays in producing that good or providing that service.

Sometimes, however, when you purchase a good or service others who were not directly part in that transaction benefit or suffer as a result. Economists call these costs or benefits EXTERNALITIES. When those not directly engaged in a transaction suffer from the consumption of a good or servce, we call that a NEGATIVE externality. Likewise, when a beneficiary of a good or service not directly engaged in the transaction doesn't pay for the benefits he/she receives, we call that a POSITIVE externality.

When externalities exist, seemingly beneficial market transactions may be inefficient or counterproductive and wasteful from the perspective of the total society. In these cases, government regulation, taxes, or subsidies might be justified to either lessen society's costs by limiting activities that cause negative externalities or increase society's benefits by encouraging activities that have positive externalities.

Some Examples of Externalities

two examples of negative externalities

1) Air pollution from incinerators create hazardous breathing conditions and possible illness for people that live down wind. However, the cost of associated medical care caused by such pollution is not paid for by the polluter who is the cause of the illness.

2) (thanks to Prof. Roger McCain of Drexel Uniersity)

Fish have been in the news, recently, as major world fisheries have been overexploited and are now very unproductive. In the North Atlantic Region, in particular, many fishermen have been thrown out of work in the 1990's because there are just not enough fish to catch.

Of course, this is an evironmental problem and a biological problem, but first and foremost, it is an economic problem, a problem of resource allocation. Here is what I mean.

When a fisherman catches a fish and sells it, that fisherman gets a private benefit -- the revenue from selling the fish. But there is a cost -- because there are fewer fish to reproduce, there will be less fish caught (ceteris paribus) in the next and future years. This cost is spread out over all the fishermen and consumers of fish, and thus is "external" to the individual fisherman's decision how many fish to take. The individual fisherman does not take into account the influence of his fishing on the fish that will be available to other fishermen in the future -- it he isn't going to catch them, why should he care? The result is that he does not limit his catch in such a way as to conserve the fish population to reproduce, and this is why fisheries are overexploited.

In effect, when a fisherman cuts back on his catch to leave fish in the water so that the fish can reproduce, the fisherman is investing. He is creating a capital resource: breeding fish. But since he doesn't get (most of) the benefits of this investment, the fishing industry as a whole doesn't invest enough in breeding fish. The world as a whole has allocated too little to investment in breeding fish, and too much to other purposes.

In contrast, a positive externality is an unpaid-for benefit enjoyed by others in society. Market economies tend to undervalue the full social value of the good or service generating the positive externality. As a consequence, an inefficiently small amount of the good is produced (or "underinvestment"). A common government intervention is to subsidize those activities that generate positive externalities.

two examples of positive externalities :

A) When a commuter chooses public transportation instead of a private car, that choice decreases congestion ("traffic") on the highways. One less car, a bit less congestion -- but the benefit of the decrease in congestion goes to the commuters who continue to use their cars, not to the public transportation commuter. So, the beneficiary (the car commuter) didn't pay for the benefit (less traffic and so an easier commute). Accordingly, the benefit of decreased congestion is an external benefit, from the point of view of the public transportation commuter.

B) Rapid growth of a high-tech company with computer-savvy workers may increase the reputation of the area where the company is located, helping all firms in the area attract similar types of workers.