What Is an Externality?

An externality is the effect of a purchase or decision on a person group who did not have a choice in the event and whose interests were not taken into account. Externalities, then, are spillover effects that fall on parties not otherwise involved in a market as a producer or a consumer of a good or service. Externalities can be negative or positive, and externalities can result from either the production or the consumption of a good, or both.

Negative externalities impose costs on parties not involved in a market, and positive externalities confer benefits on parties not involved in a market.

Cost of a Negative Externality

A classic example of a negative externality is pollution. An enterprise that emits pollution while producing a product certainly benefits the owner of the operation, who is making money off the production. However, the pollution also has an unintended effect on the environment and the surrounding community. It affects others who had no choice in the matter and were probably not taken into account in production decisions, and is thus a negative externality.

Benefit of a Positive Externality

Positive externalities come in many forms. Commuting to work by bicycle involves the positive externality of combatting pollution. The commuter, of course, gets a health-related benefit of the bike trip, but the effect this has on traffic congestion and reduced pollution released into the environment because of taking one car off the road is a positive externality of riding a bike to work.

The environment and community were not involved in the decision to commute by bike, but both see benefits from that decision.

Externalities of Production Versus Consumption

Externalities involve both production and consumption in a market. Any spillover effects that are conferred on parties not involved in producing or consuming are externalities, and both can be positive or negative.

Externalities of production happen when producing a product confers a cost or benefit to a person or group who has nothing to do with the production process. So, as noted in the pollution example, the pollutants produced by a company are a negative externality of production. But production can also produce positive externalities, such as when a popular food, such as cinnamon buns or candy, produces a desirable smell during manufacturing, releasing this positive externality to the nearby community.

Consumption externalities include second-hand smoke from cigarettes, which imparts a cost on people nearby who are not smoking and is thus negative, and education, because the benefits of going to school that include employment, stability, and financial independence have positive effects on society, and are thus a positive externality.