An externality is a benefit or cost which “spills over” to a third party.
Externalities can be positive or negative.
Positive Externality — taking care of my front lawn.
This is a positive externality because the benefits of a tidy front lawn accrue to my entire neighbourhood by making it more attractive and pleasant to my neighbours. That is, my neighbours don’t have to incur the cost of taking care of my lawn, but the incur spillover benefits from my activity.
Negative Externality — pollution.
Pollution is the most common example of a negative externality. If I throw my trash in the streets around my neighbourhood the negative consequences affect my neighbours as much as they do me.
Why is it important?
Externalities take place any time the market fails to fully price the full effects of an activity.
In such a case where externalities are not fully priced in, too much of a good will be produced because someone else will pay for these costs. If there is a positive externality, too little of the good is produced because the producer doesn’t receive all of the benefits associated with the action.
In a more general sense, externalities distort incentives causing us to engage in too much or too little of an activity.
Thinking about externalities resulting from certain actions will help us to consider alternative actions that otherwise we might not if taking into account only the direct costs and benefits.