An externality is a cost or benefit experienced by a third party due to the actions of an individual or company.

Without incentives for actors to address externalities market forces dictate that they will not. Doing so would put them at a disadvantage to their competitors.

This is a Market failure which has detrimental effects on the efficiency of a society as a whole.

Examples of negative externalities:

  • A production company emits pollution which reduces air quality, damages crops, and reduces public health outcomes.
  • A homeowner’s messy front garden looks ugly and attracts pests which reduces land value in neighboring properties.

Examples of positive externalities:

  • A honey producer keeps bees which also pollinate nearby crops.
  • Vaccination among a population decreases risk of infection to the unvaccinated members.

Possible solutions:

Externalities can be ‘internalised’ to provide real incentives for addressing them, or to provide funds to those who might.

  • Governmental regulation can create explicit internal costs or benefits by way of laws, penalties, taxes, rebates, etc. For example, a law against dumping trash, a tax on carbon emissions.
  • Lawsuits can compel those incurring the externalities to compensate those negatively affected by them.
  • Clarified and expanded property rights: When ownership of something is clear the owner will have an incentive to maintain its utility. If a brewery owned an adjacent lake for example.

Further reading: