Economics · environment
Externalities
Definition
An externality is an effect of an economic activity on parties not involved in the transaction, where the effect does not work through the price system (Laffont's New Palgrave formulation). Negative externalities impose uncompensated costs — pollution, congestion, carbon emissions; positive externalities confer uncompensated benefits — vaccination, education, pollination by an adjacent apiary. The concept was systematised by Arthur Pigou in The Economics of Welfare (1920), which proposed taxes and subsidies to internalise the divergence between private and social cost (Pigouvian instruments).
References
Pigou 1920 origin, negative/positive typology, Pigouvian taxes
definition as indirect effect not operating through the price system
Overview
What it means
Externalities are the canonical case of market failure: because the emitter or beneficiary does not face the full social cost or value of their action, markets overproduce harm and underproduce benefit. Environmental policy — carbon pricing, effluent charges, cap-and-trade, subsidies for public goods — is largely the applied art of internalising externalities.
How it is used
Used in cost-benefit analysis, environmental tax design, true-cost accounting, natural-capital valuation and justifications for regulation and corrective pricing.
Why it matters
The externality concept explains why unpriced environmental damage persists in market economies and supplies the theoretical foundation for carbon pricing and polluter-pays instruments. **Note:** "External cost" (candidate 1045) and the singular "externality" (1047) are treated as a merge and an alias of this entry respectively.