An externality is a Cost and/or Benefit arising from an Activity of one economic actor which is experienced by another economic actor without this cost or benefit being part of the price of the Good or Service supplied by the first actor. This concept is fundamental to understanding market failures and the full societal impacts of economic activities.
Externalities represent the disconnect between private costs or benefits (those experienced by the producer or consumer directly involved in an economic transaction) and social costs or social benefits (the total impact on society as a whole). When these differ, markets fail to allocate resources efficiently because prices do not reflect the true costs or benefits to society.
Importantly, externalities can arise not only from activities themselves, but also from a failure to act. A common example is government failure to ensure a regulated market, where the absence of appropriate oversight creates negative consequences for economic actors who are not party to the initial decision to refrain from regulation.
Externalities are categorised into two fundamental types based on their impact on human wellbeing. Positive externalities, also called external benefits, occur when an activity creates gains in human wellbeing for other economic actors. Examples include the educational benefits to society when individuals pursue higher education, or the aesthetic improvements neighbours enjoy when a homeowner maintains an attractive garden. Negative externalities, also called external costs, occur when an activity creates losses in human wellbeing for other economic actors. Classic examples include air pollution from industrial production or noise pollution from construction activities.
From an economic efficiency perspective, achieving optimal resource allocation requires that externalities be Internalised. This means adjusting prices to reflect the full social costs and benefits of activities. For instance, the value of a loss of welfare should be paid by the agent causing the externality by an amount equal to the damage cost. This principle underpins many environmental policy instruments such as pollution taxes, emissions trading schemes, and regulatory standards that seek to incorporate external costs into decision-making processes.
