Definition
Externality
A cost or benefit that falls on a third party not involved in a market transaction.
Definition
A cost or benefit that falls on a third party not involved in a market transaction.
Why It Matters
When markets create externalities, the private price diverges from the social cost, leading to overproduction of harmful goods or underproduction of beneficial ones. Externalities are a core justification for government intervention.
Policy Example
Education generates positive externalities: a more educated population benefits society through lower crime, better civic participation, and faster innovation. Individual students, however, do not fully capture these benefits in their own wages. This is why education is publicly subsidized.
In Context