Externality

When the price of an activity does not capture all its costs or benefits, the people left out, third parties, bear the difference. Those spillovers are externalities.

An externality is a cost or benefit from an economic activity that falls on third parties who are not part of the transaction, and which is therefore not reflected in the market price. Externalities are a central source of market failure, because they drive a wedge between private and social costs or benefits.

Negative and positive

Externalities come in two forms. A negative externality imposes uncompensated costs on others, as pollution harms those downwind, or traffic congestion delays everyone else. A positive externality confers uncompensated benefits, as a beekeeper's bees pollinate a neighbour's orchard, or education and research benefit society beyond the individual. In both cases the price the market sets ignores the spillover, so it sends the wrong signal about how much of the activity is worthwhile.

Why they cause inefficiency

The harm of externalities is that they lead the market to produce the wrong amount. Because a polluter bears only its private cost, not the full social cost including the harm to others, it produces too much of the polluting activity from society's standpoint. Because someone investing in education or research captures only part of the benefit, too little is produced. The market, guided by prices that omit the externality, over-produces things with negative externalities and under-produces those with positive ones, an inefficiency that pure private incentives will not correct.

Correcting them

Several remedies try to close the gap between private and social costs. Taxes on negative externalities, such as a carbon tax, make the producer bear the social cost, the polluter pays. Subsidies for positive externalities encourage activities whose benefits spill over. Regulation can limit harmful activities directly. Tradable permits create a market in the right to impose an externality. And, where bargaining is cheap and rights are clear, the Coase theorem suggests private negotiation may suffice. Each aims to make decision-makers internalise the costs or benefits they would otherwise ignore.

Externalities are one of the most important ideas in economics, the recognition that prices often fail to capture the full effects of an activity on others, and that markets left alone will then get the quantity wrong. They are the analytical heart of environmental economics and much public policy, the reason that pollution, congestion, research, and vaccination cannot be left entirely to a market that ignores their spillovers.