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An externality is a cost which is not figured into the consumer price, but is borne by the public. In economics, an externality (or transaction spillover) is defined as a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit. There are negative and positive externalities. A negative externality is a cost which is not figured into the consumer price, but is borne by the public. A typical example is environmental damage. A positive externality is a benefit that accrues to the public, but does not benefit the producer. Public goods have positive externalities.
In these cases in a competitive market, prices do not reflect the full costs or benefits of producing or consuming a product or service; producers and consumers may either not bear all of the costs or not reap all of the benefits of the economic activity, and too much or too little of the good will be produced or consumed in terms of overall costs and benefits to society. For example, manufacturing that causes air pollution imposes costs on the whole society. If there exist external costs 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, 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. "Internalization" of negative or positive impacts, by legal or other means, can help more accurately reflect the full costs of activities.
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- Jean-Jacques Laffont (2008). "externalities" The New Palgrave Dictionary of Economics, 2nd Ed. Abstract.
- Kenneth J. Arrow (1969). "The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Non-market Allocations," in Analysis and Evaluation of Public Expenditures: The PPP System. Washington, D.C., Joint Economic Committee of Congress. PDF reprint as pp. 1-16 (press +).
- Erik Reese, "Moving Mountains," Orion, Jan/Feb 2006.
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