What are externalities in economic terms?

Externalities in economic terms refer to the benefits or costs that are experienced by parties who are not directly involved in a particular economic transaction or decision. This concept captures the impact that the actions of individuals or businesses can have on third parties. For example, pollution from a factory can negatively affect the health of nearby residents who are not involved in the production process, representing a negative externality. Conversely, a well-kept garden in a neighborhood may increase property values for those living nearby, which showcases a positive externality.

The recognition of externalities is crucial because they can lead to market failures, where the true cost or benefit of a good or service is not reflected in market prices. This discrepancy can result in overproduction of goods that generate negative externalities (like pollution) or underproduction of goods that generate positive externalities (like education). Understanding externalities is essential for economists when evaluating the social impact of economic activities and devising appropriate policies or regulations to address these side effects.