Externality

An externality, also called a spillover, occurs when production, consumption or another economic activity affects a third party who is not part of the relevant transaction. In the standard technical sense, the effect is external because the people making the decision do not fully bear the associated cost or receive the benefit, and it is not adequately reflected in prices or agreements. This is different from an ordinary price effect: for example, a buyer's purchase that raises the market price paid by other buyers is generally transmitted through the market rather than treated as a technical externality. External effects vary in size and may affect a neighbor, a community or people across national borders.

A negative externality imposes a cost on people outside the transaction. Pollution is a common example: a producer and its customers may benefit from a product while nearby residents bear health, environmental or other costs that the producer does not pay. Noise and traffic congestion can also impose costs on nonparticipants. A positive externality gives an outside party a benefit for which they do not compensate the person or organization creating it. Research and development can spread knowledge beyond the firm that paid for the research, and a beekeeper's activity can benefit nearby farms through pollination. These effects may arise from either production or consumption.

Externalities matter when private incentives differ from the full costs or benefits of an activity to society. For a harmful spillover, a producer who does not pay for external damage may face lower private costs than the total social costs; the market can then produce more of the activity than would be efficient after those costs are counted. With a beneficial spillover, the decision-maker may receive only part of the total social return, which can lead to less activity than would be socially beneficial. These are possible outcomes, not automatic rules: contracts, prices or institutions may already account for some effects, and the scale and distribution of costs and benefits must be assessed in context.

Possible responses include taxes or charges that make a source of harm face more of its external cost, subsidies for activities with wider benefits, direct standards or regulation, tradable permits, and agreements between affected parties when bargaining is practical. A tax or subsidy calibrated to the marginal external effect is a classic economic proposal, but finding the right amount requires information about the effects and who bears them. Measurement, enforcement, administrative and bargaining costs, uncertainty and distributional consequences can limit any response. No single instrument is appropriate for every externality.

The concept is used in environmental economics, public finance, health, education and innovation policy. Greenhouse-gas emissions are a cross-border negative externality because many costs are borne by people beyond those who benefit from emitting activities. Research spillovers and benefits that reach beyond the original participants help explain why governments and institutions sometimes support research, infrastructure or other activities. Externalities are one important source of market failure, but identifying one does not by itself determine which policy is best; evidence about impacts and feasible alternatives is also needed.