Externality

CORE DEFINITION

In economics, an externality (or external cost, spillover effect) is an indirect cost or benefit to an uninvolved third party arising from the activities of another party (or parties). Externalities can be viewed as unpriced goods involved in market transactions between consumers or producers. An example is air pollution caused by vehicle exhaust. The cost of air pollution to society is not paid by the vehicle producers or users to other members of society. Water pollution from factories is another example. All consumers are made worse off by pollution, but the market does not compensate for this damage. A positive externality occurs when an individual's consumption in the market increases the well-being of others, but the individual does not charge the third party for the benefit. The third party essentially gets a free product. An example might be an apartment above a bakery that enjoys the smell of fresh pastries every morning. The apartment residents do not compensate the bakery for this benefit. The concept of externalities was first proposed by economist Arthur Cecil Pigou in the 1920s. A typical example of a negative externality is environmental pollution.