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An externality or external cost in economics is a cost or benefit which occurs to an individual or group of individuals who are not directly involved in the market transaction which causes it. Alternatively an externality can be seen as a cost or benefit which an economic agent imposes on an innocent bystander, and is often referred to as a spill-over effect from the activity.[1] Some of the original contributions to the theory of externalities come from British economist A.C. Pigou in the early 20th century, with the theory now commonly associated with welfare economics.[2] A positive externality is one which involves a benefit, while a negative externality is one which involves a cost. Externalities are of interest to economists due to the fact that positive and negative eternalities occur outside of the market transactions and are thus not properly reflected in price. Furthermore because externalities are not properly reflected in prices individuals who are involved in activities which produce them have no economic incentive to take them into account. As such it is commonly supposed that individuals engage excessively in actions that produce negative externalities and insufficiently in activities which produce positive externalities.[1]

A common example of a negative externality is the pollution emitted by a factory which decreases the air quality of surrounding areas, imposing a cost on residents of the effected area. An example of a positive externality is the beautification of one's property, i.e., if one plants a rose bush on their front lawn while they will bear the whole cost their neighbours, along with them, will also benefit.


  1. 1.0 1.1 Spulber, Daniel. "Famous Fables of Economic – Myths of Market Failures", 2002, page 8.
  2. Callahan, Gene. "Economics for Real People", 2004, page 243.

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