Glossary · Economic ideas
Externality
An externality is a cost or benefit that lands on people outside a deal, like smoke from a factory or the bees of a beekeeper next to an orchard.
Also called: external cost, external benefit, spillover, negative externality, positive externality, third-party effect
In plain words
Your neighbor throws a party until 3 a.m. They have fun, the DJ gets paid, and you lie awake. You weren’t part of the deal, but you paid part of its cost. That spillover is an externality.
Negative externalities are costs dumped on others: pollution, noise, traffic jams, antibiotics overused until germs resist them. Positive externalities are benefits others get for free: a vaccinated person also protects their neighbors, a lovely garden cheers up the street, one firm’s research helps others.
Markets struggle with them because prices leave them out. Things with hidden costs end up too cheap and overused; things with hidden benefits end up too rare.
Example
The price that leaves out the smoke
A factory makes a gadget for $8 and sells it for $10. Its smoke does $3 of harm to the neighbors for each gadget, but nobody bills the factory for that.
- Cost the factory counts: $8. Cost to everyone together: $8 + $3 = $11.
- A buyer who values a gadget at $10 buys it, though it costs society $11 to make: each such sale leaves the world $1 worse off.
- Charge the factory $3 a gadget, through a pollution fee or a cleanup rule that costs the same, and its price rises to about $11. Now only buyers who value a gadget at $11 or more buy one.
Making the polluter pay the $3 is called internalizing the externality: the price then tells the whole truth.
One level deeper
The economist Arthur Pigou proposed in 1920 to tax activities with external costs by the amount of the harm. Such charges are now called Pigouvian taxes; fees on pollution and congestion charges for driving into city centers follow the idea.
Ronald Coase pointed out in 1960 that if property rights are clear and bargaining is cheap, the people affected can sometimes settle it themselves: the neighbors could pay the factory to fit a filter, or the factory could pay them. When millions of people are affected, bargaining is impossible, and rules usually step in.
Externalities are one of the main reasons markets can fail, along with public goods and monopoly. The tragedy of the commons is a special case: every user of a shared resource imposes a small cost on all the others.
Why it matters
They explain many of the world’s big problems, from polluted air to overfished seas, and why markets alone don’t fix them.
They are behind many taxes, subsidies and rules, from fuel taxes to school vaccination programs, so how big an externality is often decides a policy debate.
Positive ones explain why some useful things, like basic research, get too little private money.
A common mistake
Myth: If a product sells at a profit, it is worth what it costs.
In fact: Only if its price includes all the costs. When some costs fall on outsiders, a profitable product can still cost society more than it is worth.
Questions people ask
What is an example of a negative externality?
Smoke from a factory, noise from an airport, traffic jams (each driver slows down all the others) and secondhand smoke from cigarettes.
What is an example of a positive externality?
Vaccination (it protects the people around you), education (an educated population helps everyone), and a beekeeper’s bees pollinating a neighbor’s orchard.
How can externalities be fixed?
With taxes or fees equal to the harm, rules and limits, tradable permits, subsidies for positive externalities, or, when only a few people are involved, by bargaining among them.
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About the numbers
- This page explains a term. It is not investment advice.