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Externality

In economics, an externality, or transaction spillover, is a cost or benefit that is not transmitted through prices[1] or is incurred by a party who was not involved as either a buyer or seller of the goods or services causing the cost or benefit.[2] The cost of an externality is a negative externality, or external cost, while the benefit of an externality is a positive externality, or external benefit. In the case of both negative and positive externalities, prices in a competitive market do not reflect the full costs or benefits of producing or consuming a product or service. Producers and consumers may neither bear all of the costs nor reap all of the benefits of the economic activity, and too much or too little of the goods 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, while fire-proofing a home improves the fire safety of neighbors. 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. Here, overall cost and benefit to society is defined as the sum of the economic benefits and costs for all parties involved.[3][4] The term "externalities" is regularly misunderstood by some critics of economics, who allege that it is an attempt to relabel the socially disruptive consequences of corporate activity, and frame them as inevitable and acceptable.[5] However, this does not reflect the actual meaning of the term. In fact, economists often use externalities as a justification for government intervention in the economy. Standard economic theory states that any voluntary exchange is mutually beneficial to both parties involved in the trade. This is because buyers or sellers would not trade if either thought it not beneficial to themselves. However, an exchange can cause additional effects on third parties. From the perspective of those affected, these effects may be negative (pollution from a factory), or positive (honey bees kept for honey that also pollinate crops). Welfare economics has shown that the existence of externalities results in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost. A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected by the negative externalities in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on their lungs, violating their property rights. Thus, an external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly defined property rights, as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in the case of publicly owned, or literally, in some countries and/or legal traditions). On the other hand, a positive externality would increase the utility of third parties at no cost to them. Since collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will be produced than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase societal productivity and well-being; but controversial, as these benefits are generally internalized, e.g., in the form of higher wages), public health initiatives (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement. Positive externalities are often associated with the free rider problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others. There are a number of potential means of improving overall social utility when externalities are involved. The market-driven approach to correcting externalities is to "internalize" third party costs and benefits, for example, by requiring a polluter to repair any damage caused. But, in many cases internalizing costs or benefits is not feasible, especially if the true monetary values cannot be determined.

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