In economics, an externality is an impact on any party not directly involved in an economic decision. An externality occurs when an economic activity causes external costs or external benefits to third party stakeholders who cannot directly affect an economic transaction. In other words, the producers and consumers in a market either do not bear all of the costs or do not reap all of the benefits of the economic activity. For example, manufacturing that causes air pollution imposes costs on others, while planting forests (rather than other agricultural activities) would improve the water quality of those downstream.

In a competitive market, the existence of externalities would mean that either too much or too little of the good would be produced and consumed in terms of overall cost and benefit to society. If there exist external costs (negative externalities) such as pollution, the good will be overproduced by a competitive market, as the producer does not take into account the external costs when producing the good. If there are external benefits (positive externalities) such as in areas of education or public safety, too little of the good would be produced by private markets as producers and buyers do not take into account the external benefits to others. Here, overall cost and benefit to society is defined as the sum of the economic benefits and costs for all parties involved.

Implications

Standard economic theory implies that any voluntary exchange is mutually beneficial to both parties involved in the trade. This is because if either the buyer and the seller would not benefit from the trade, they would refuse it. An exchange however, can result in additional effects on third parties. From the perspective of those affected, these effects may be negative (pollution from a factory), or positive (honey bees that pollinate the garden). Welfare economics has shown that the existence of externalities result in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost.

A voluntary exchange may actually reduce societal welfare if external costs exist. The person who is affected by the negative externality in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on their lungs, violating their property rights. Thus, an external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights, as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries and/or legal traditions).

An external benefit, on the other hand, would increase the utility of third parties at no cost to them. Since collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will be produced than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase societal productivity and well-being; but controversial, as these benefits may be internalized), health care (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement. Positive externalities are frequently associated with the free rider problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.