An externality is an economic principle that refers to the costs or benefits of a transaction or activity that affect third parties who are not directly involved in the transaction. These effects are not reflected in the market price of the goods or services involved. Externalities can be:
1. Positive Externalities: Benefits that are enjoyed by third parties without compensation, such as improved air quality from widespread tree planting or the broader societal benefits of education.
2. Negative Externalities: Costs imposed on third parties without compensation, such as air pollution from industrial production or traffic congestion caused by excessive driving.
Because externalities are not accounted for in market transactions, they often lead to market failures, where the market outcome does not reflect the true social cost or benefit of the activity. Governments and policymakers may intervene to correct these failures using tools like taxes, subsidies, regulations, or tradable permits.
