In economics, an externality is defined as a cost or a benefit stemming from a transaction that affects various third parties who are not part of the transaction. The effect can be a benefit to the third party, called a “positive externality,” or it can be a cost, called a “negative externality.” Externalities disrupt the efficiency of a market because the prices in the individual transactions will not reflect the costs or benefits imposed by the externality. Governments will often try and account for these outside factors through various methods of regulation.
An efficient market is one that finds the ideal price for the general welfare of society in the production of a good or provision of a service given the supply and demand. There are few transactions that do not involve an unforeseen externality that confers costs or benefits on society at large and disrupts this efficiency. This is a result of the fact that externalities are generally unaccounted for by both private companies and consumers when making their transactions, as they are difficult to ascertain in the context of an individual transaction.
The classic example of a negative externality is the polluting company. This hypothetical company that produces widgets takes into account the demand for their product, the production cost, as well as any overhead in operating their widget factory in determining their price. Likewise, the consumer will consider only what they want to pay to own a widget in deciding whether or not to purchase the item. What neither party considers is the societal cost of the production of widgets, which happens to pollute the air surrounding every place in which a widget factory is located.
An externality does not need to be negative. For instance, the increasing prevalence of education in society is an example of an economic event with a variety of positive externalities. Any society that is populated by well-educated people will benefit from the knowledge resulting from time and money spent by those people on their education. Technological and medical advances stemming from that knowledge will benefit not only those who make such developments, but those who belong to the society that has access to the advances made by its educated citizens. These advances are examples of positive externalities.
Governments will try to account for these factors through a variety of regulations in order to limit negative externalities and promote activity that leads to positive externalities. Criminalization of drugs in order to discourage their use and the subsequent destructive effects such as an increase in violent crime is one method. Higher taxes on unhealthy products such as tobacco and alcohol are designed to discourage their purchase and consumption. Additionally, governments may promote positive externalities through subsidies that lower the cost of production or consumption of a good or service that has beneficial effects on its society.