Definition
When an orchard opens next to a beekeeper, the bees collect more honey and the apple trees set more fruit. No money changed hands, yet both sides benefited. When one person's activity leaves a benefit or a cost on someone nearby without anyone paying or being paid for it, that is called an externality.
Benefits That Travel Without a Payment
Say a new orchard opens next to a hill where a beekeeper keeps his hives. The two have never signed a contract, and they have never exchanged money.
Yet the bees fly around the apple blossoms and bring back nectar. The apple trees set more fruit because the bees carried the pollen. Each side got a free gift from the other.
That benefit isn't written on anyone's price tag. Neither the price of the honey nor the price of the apples counts the "extra share thanks to the neighbor." If you only look at the money that moved through the market, you won't even notice this benefit.
A benefit like this, passing quietly outside the market, is called a positive externality. A tree someone planted along an alley, cooling the summer walk of people passing by, is the same kind of story.
Costs That Drift Away Like Chimney Smoke
Costs can spill over too. When a factory upstream dumps wastewater into the river, people in a town downstream, who have nothing to do with the factory's business, find the water hard to use.
The factory pays for materials and wages when it makes its goods. But it doesn't pay for dirtying the river. That bill gets paid by someone else, in the form of the townspeople's trouble and the cost of cleaning the water back up.
So the cost the factory counts is smaller than the cost society actually pays. Because the price is set too low, the factory ends up making more than is right for society.
With positive externalities, the opposite happens. The benefit that goes to others never shows up in the price, so helpful activities, like caring for an alley, don't happen as much as society would like.
A Bit More Precisely: Putting a Price on It and Bringing It Back In
To be a bit more precise, an externality is a problem the market has trouble solving on its own. Supply and demand can't notice a gain or a loss that isn't written on a price tag.
So the fix is to pull the value that leaked out back inside the price. Activities that leave a cost on others get a tax or a fee. Helpful activities get a subsidy on top.
Another method is to set a limit on how much pollution can be released and let people buy and sell the right to emit it. That puts a price on it so that whoever emits less comes out ahead. The advantage is that the factories that can cut back most easily do so first.
When the interests involved sit with just a few people and they can talk to each other easily, the parties sometimes settle it by agreement. In fact, one study found that in the United States, contracts where orchards pay beekeepers for pollination are common. Whichever path you take, the goal is the same: put the value that spilled over back onto the price tag.
Common misconceptions
An externality only means bad things, like pollution or noise.
There are positive externalities too, where a benefit spills over. Bees and an orchard are a case where both sides share a benefit without any money changing hands.
An externality is when the two people who made a trade share the loss.
The key point is that a benefit or a cost lands on someone who isn't part of the trade. Because that share has no price, the market can't adjust the amount by itself.
Where you meet it
Roses a neighbor planted along the fence brighten up the alley in front of your house too
The sound of a motorcycle racing down the alley late at night keeps the houses around it from sleeping well
In one sentence
An externality is a benefit or a cost that passes to people outside a trade without any payment; because it isn't captured in prices, the market can't adjust it on its own.