Introduction to Externalities

Economics: IB Diploma, topic 1.4.2

Externalities

Externalities occur when third parties are affected by private market transactions. Externalities can be either negative or positive.

Private markets, such as the cell phone industry, offer an efficient way to put buyers and sellers together and determine what goods they produce, how they produce them and who gets them.
The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking.
However, what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller?

As an example, consider a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighborhood.
You will be able to hear these outdoor concerts while sitting on your back porch—or perhaps even in your dining room.
In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction.
Externalities can be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality (and vice versa!).

The effect of a market exchange on a third party who is outside or “external” to the exchange is called an externality.
Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spillovers.