What Are Externalities in Economics?
Examples of Positive and Negative Externalities

In economics, many decisions are made by individuals, households, and firms. Usually, these decisions affect the people who make them directly. However, sometimes an action also affects others who were not part of the decision and did not agree to it. Economists call these side effects externalities.

Understanding externalities is important because they explain why markets sometimes fail to produce the best outcomes for society and why governments may step in with rules, taxes, or subsidies.

What are externalities?

An externality is a cost or benefit created by an economic activity that affects a third party who is not directly involved in that activity.

In simple terms, an externality happens when:

• Someone makes a decision,

• That decision affects other people,

• And those affected people are not compensated and did not choose to be part of the transaction.

Externalities can be either:

• Positive externalities – when the activity creates benefits for others.

• Negative externalities – when the activity creates costs or harm for others.

The key point is that these effects are outside the market price. The price paid by the buyer and received by the seller does not fully reflect the true cost or benefit to society.

Why do externalities matter?

Markets work well when prices reflect all the costs and benefits of producing and consuming a good. But when externalities exist, prices send misleading signals.

As a result:

• Goods that create negative externalities are often overproduced.

• Goods that create positive externalities are often underproduced.

This situation is known as market failure.

Negative externalities

A negative externality occurs when an activity imposes a cost on others who are not involved in the decision.

The person or firm creating the harm does not pay for the full damage caused. Because of this, the activity appears cheaper than it truly is for society.

Example 1: Air pollution from factories

Suppose a factory produces steel. It sells steel to customers and earns profits. However, the production process releases smoke and harmful gases into the air.

People living nearby may suffer from:

• breathing problems,

• damaged buildings,

• reduced quality of life.

These residents are not part of the steel market transaction, yet they bear real costs. The factory only considers its private costs (machines, labor, raw materials), not the health and environmental damage.

This is a classic negative externality.

Example 2: Car use and traffic congestion

When one person decides to drive a car, they benefit from comfort and speed. But each extra car adds to congestion and increases travel time for everyone else on the road.

Other drivers experience longer delays, even though they did not agree to this extra congestion. The driver creating the delay does not pay those affected.

Traffic congestion is therefore a negative externality of driving.

Example 3: Noise pollution

Consider a nightclub playing very loud music late at night. Customers enjoy the music, and the owner makes money. However, people living nearby may suffer from loss of sleep and stress.

The disturbance to neighbors is a negative externality because it creates costs for third parties.

Consequences of negative externalities

When negative externalities exist, the market tends to produce too much of the harmful activity. This is because the producer or consumer only considers their private benefit and private cost, not the wider social cost.

From society’s point of view, the true cost is higher than what the market price shows.

Positive externalities

A positive externality occurs when an activity creates benefits for others who are not involved in the transaction and who do not pay for those benefits.

In this case, the person creating the benefit does not receive full compensation.

Example 1: Education

When a student invests in education, the student benefits by gaining knowledge, skills, and better job opportunities. However, society also benefits in many ways:

• a more productive workforce,

• lower crime rates,

• higher civic participation,

• more innovation.

These wider social benefits are enjoyed by many people, not just the student or the school. Because students cannot capture all these benefits, education creates a positive externality.

Example 2: Vaccination

When someone gets vaccinated, they reduce their own risk of becoming ill. But they also reduce the risk of spreading disease to others.

This protection of others, often called herd immunity, is a positive externality. People around the vaccinated person benefit even though they are not directly part of the decision.

Example 3: Home improvements

Suppose a homeowner renovates their house and improves the garden. The owner enjoys a nicer living environment. But the neighbors may also benefit because:

• the area looks better,

• property values in the neighborhood may rise.

These spillover benefits are positive externalities of home improvement.

Consequences of positive externalities

When positive externalities exist, the market tends to produce too little of the beneficial activity.

This happens because individuals only consider their private benefit. They ignore the additional benefits that others receive. From society’s point of view, the total benefit is higher than what the decision-maker considers.

As a result, activities such as education, research, and vaccination would be underprovided if left entirely to the market.

Externalities and social costs and benefits

To understand externalities clearly, economists distinguish between:

• Private cost and benefit – what the decision-maker experiences.

• Social cost and benefit – the total cost or benefit for everyone in society.

For negative externalities:

• Social cost = private cost + external cost.

For positive externalities:

• Social benefit = private benefit + external benefit.

When private and social values differ, the market outcome is not socially efficient.

How governments respond to externalities

Because externalities lead to inefficient outcomes, governments often try to correct them.

Policies for negative externalities

Common solutions include:

• Taxes on harmful activities, such as pollution taxes or fuel taxes.

• Regulations, such as limits on emissions or noise levels.

• Tradable permits, where firms must hold permits to pollute.

These policies aim to make producers and consumers take into account the costs they impose on others.

Policies for positive externalities

For positive externalities, governments often use:

• Subsidies, such as financial support for education or renewable energy.

• Public provision, such as public schools or public health programs.

• Information campaigns, encouraging beneficial behavior like vaccination.

The goal is to encourage more of the socially beneficial activity.

A simple comparison

Conclusion

Externalities are an important concept in economics because they show that individual decisions can affect many people beyond buyers and sellers. A negative externality occurs when an activity imposes costs on others, such as pollution, congestion, or noise. A positive externality occurs when an activity creates benefits for others, such as education, vaccination, and neighborhood improvements.

When externalities exist, markets on their own do not lead to the best outcomes for society. Negative externalities result in overproduction, while positive externalities result in underproduction. For this reason, governments often use taxes, regulations, subsidies, and public services to bring private decision-making closer to what is best for society as a whole.

In short, externalities remind us that economic choices rarely affect only the person who makes them—they often shape the well-being of the entire community.