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Externality

Definition

An externality is a cost or benefit that affects a third party who is not directly involved in the production or consumption of a good or service.

Analogy

Imagine you live in an apartment building and your neighbor plays loud music late at night. The noise bothers other residents who are not involved in the music playing, causing them to experience a negative externality.

Related terms

Negative Externality: A negative externality occurs when the production or consumption of a good imposes costs on third parties. For example, pollution from factories negatively affects the health of nearby residents.

Positive Externality: A positive externality occurs when the production or consumption of a good benefits third parties. For instance, education provides knowledge and skills to individuals, but it also benefits society as a whole by creating an educated workforce.

Market Failure: Market failure refers to situations where markets fail to allocate resources efficiently due to externalities, imperfect competition, information asymmetry, or public goods. It highlights instances where government intervention may be necessary.