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This is a term used by economists to refer to effects of a transaction or economic decision that affect others beyond the immediate parties to the transaction.

• Either there are external benefits received for free by some outside the transaction (positive externalities), or
  
• There are costs or negative effects borne involuntarily by people not party to the transaction (negative externalities).

Examples:

Burning fossil fuels generates greenhouse gasses which (probably) contribute to global warming. This warming will have expensive negative impacts on many other people around the world. Those other people will either have their quality of life reduced, or will have to pay to mitigate the effects of warming. The cost of this mitigation, caused by someone else's initial decision to burn fossil fuels, will not be charged back to those making that initial decision. Those costs are negative externalities of the decision to use fossil fuels.

If you own a house that is run down, and you decide to paint it and fix it up, you bear all the costs of those improvements. The value of your property increases. But the value of your neighbors' properties may also increase, since you have made the whole neighborhood more attractive. They didn't have to pay anything for that benefit. That is a positive externality of your decision to paint your house.

Thus externalities are sometimes called "neighborhood effects", although the neighborhood may be global.

Whenever an economic decision forces others, who didn't directly benefit from the decision, to bear additional costs, or gives others costless benefits, an externality is associated with that decision.

The reason externalities are important is that they can lead to inefficiencies in markets. If people don't bear the full cost of using a product (e.g. fossil fuel), they will tend to buy more of it than they otherwise would. So they impose more external costs. On the other hand, if some of the benefit of a transaction goes to people who bear none of its cost, fewer people may decide to make that transaction. Thus nobody gets any of the benefit.

This information supports the post "Does Recycling Make Sense" at Science in Action. Click here to return to the article.