An externality is a cost or a benefit that falls not on the person(s) directly involved in an activity, but on others.


Externalities can be positive or negative

A positive externality is a benefit that falls on a person not directly involved in an activity

A negative externality is a cost that falls on a person not directly involved in an activity

Externalities are a source of market failure

An externality occurs when the benefits or costs to society differ from the benefits or costs to the individual who is responsible for them.

Such differences occur in four situations:

negative externalities in production
positive externalities in production
negative externalities in consumption (for demerit goods)
positive externalities in consumption (for merit goods)

Resources are not allocated in an ideal way: too few or too many resources are likely to be directed to the production of certain products.