What are externalities in economic terms?

Externalities in economics refer to costs or benefits that affect third parties who are not directly involved in a transaction. These can occur in both positive and negative forms. For instance, when a factory pollutes a river, the surrounding community suffers the negative externality of pollution, even though they are not part of the factory's production process. Conversely, consider a homeowner who maintains a beautiful garden; this can provide a positive externality to neighbors and passersby who enjoy the improved aesthetic of the neighborhood without having contributed to the garden's upkeep.

The significance of understanding externalities lies in recognizing that market transactions can have broader impacts beyond the immediate buyer and seller, potentially leading to inefficiencies in resource allocation. In many cases, such externalities may justify government intervention to help align private incentives with social welfare, such as through taxes on negative externalities or subsidies for positive ones.