English

Noun

externalities

1. Plural of externality

In economics, an externality is an impact (positive or negative) on any party not involved in a given economic transaction.

An externality occurs when a decision causes costs or benefits to third party stakeholders, often, although not necessarily, from the use of a public good. In other words, the participants in an economic transaction do not necessarily bear all of the costs or reap all of the benefits of the transaction. For example, manufacturing that causes air pollution imposes costs on others when making use of public air. In a competitive market, this means too much or too little of the good may be produced and consumed in terms of overall cost or benefit to society, depending on incentives at the margin and strategic behavior.

In the absence of significant externalities, parties to an economic transaction are assumed to benefit, improving the overall welfare of society. If third parties benefit substantially, such as in areas of education or safety, the good may be under-provided (or under-consumed); if costs to the public exceed costs to the economic decision makers, such as in pollution, the good may be over-provided, in terms of overall benefit or cost to society. Here, overall benefit and cost to society are defined as the collective economic utility for society.

Implications

• Public good
• Market failure
• Coase theorem
• Social costs

References

• Definition
• Baumol, W.J. (1972), ‘On Taxation and the Control of Externalities’, American Economic Review, 62(3), 307-322.