Externality

Market prices reflect the private costs and private benefits of producers and consumers. But sometimes production or consumption imposes costs or benefits on third parties—on those who are neither suppliers nor demanders in a market transaction. For example, a paper mill fouls the air breathed by nearby residents, but the market price of paper fails to reflect such costs. Because these pollution costs are outside, or external to, the market, they are called externalities.An externality is a cost or a benefit that falls on a third party.A negative ex- ternality imposes an external cost, such as factory pollution or auto emissions. A positive externality confers an external benefit, such as driving carefully or beautifying your prop- erty. Because market prices do not reflect externalities, governments often use taxes, subsi- dies, and regulations to discourage negative externalities and encourage positive externali- ties. For example, because education generates positive externalities (educated people can read road signs and have better paying options other than crime as sources of income), gov- ernments try to encourage education with free public schools, subsidized higher education, and keeping people in school until their 16th birthdays.