Externality
IntermediateAn externality is a cost or benefit of an activity that affects people who are not directly involved in it, and that is not reflected in the price paid.
Normally, buyers and sellers consider their own costs and benefits. But some effects spill over to others. A factory that pollutes a river imposes costs on people downstream who neither work at the factory nor buy its products. A person who gets vaccinated benefits others by reducing the spread of disease.
When the spillover is harmful, it is a negative externality. When it is helpful, it is a positive externality.
Externalities cause markets to produce the wrong amount of goods. If a factory does not pay for its pollution, its costs appear lower than they really are to society, so it produces more than would be ideal. If people do not consider the benefits of vaccination to others, fewer people get vaccinated than would be best for society.
Governments respond in several ways: taxing activities with negative externalities, subsidising those with positive externalities, setting regulations or creating markets, such as carbon trading schemes, that make polluters pay for their emissions.
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